Reflections on the Crisis in Greece

Haris Vittas - September 2012

The crisis in Greece has been a dominant feature of the global economic scene over the past two years. It has also had profound international repercussions, a few of which are paradoxically not unwelcome.


On the negative side, the crisis has:

  • Led to a widening of interest rate spreads across much of the euro area.

  • Generated uncertainty about the stability and viability of the European banking sector and of the euro area project, thereby undermining business and consumer confidence within and beyond the borders of the region and even threatening to push the global economy back into recession.

  • Poisoned relations between euro area partner countries, weakened popular support for the euro project and the European integration process and affected relations between the euro zone and the rest of the world.

However, the crisis has also had some positive side-effects:


  • By dispelling the myth that the default of a country within the euro zone is not possible, it served as a useful wake-up call for the rating agencies and market participants, thereby contributing to a greatly improved valuation of country-specific risks.

  • It provided the impetus for substantial improvements in the architecture of the euro project, through:


o    The creation of the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM) which enhance the capacity of the system to manage and resolve crises

o    The negotiation of a new Pact to strengthen fiscal discipline in the euro area (and the EU more broadly)


  •  It encouraged the ECB to play an active role in the management of the crisis through the development of new instruments for providing liquidity to the banking sector as well as through interventions designed to ease pressure on euro area government bonds in the primary and secondary markets.

  •  It increased awareness among euro area policy makers of the need to assess strictly the capital adequacy of European banks and to push them to raise these ratios. Pressure for improving oversight of financial institutions across the euro area and for accelerating the integration of bank resolution and deposit insurance functions has also increased.

These changes are not sufficient to address all the weaknesses in the design of the euro, but they have substantially improved the chances that the area will be able to survive the present crisis to emerge in a much better shape than before.


This paper begins with a few observations on the nature and causes of the crisis before reviewing efforts made so far to resolve it. The paper then goes on to discuss in greater detail two interrelated issues: First, why is Greece going through a very deep recession? Second, whether there are better (less costly) ways to address the crisis.



Nature of the crisis:

The crisis is typically described as a sovereign debt crisis. While this characterization is broadly accurate (Chart 1), there are two other imbalances, the twin deficits in the government accounts and in the external current account, which are arguably more important than the level of the public debt.





In 2009, Greece’s pre-crisis annual general government budget deficit had reached the astronomical level of over 15% of GDP. It was higher than in the other two euro area countries hit by the crisis or in Spain and Italy which have experienced recurrent difficulties in raising funds in the international capital markets. A high budget deficit means that public debt was bound to see alarming yearly rises. In other words, Greece’s public debt dynamics were becoming unstable.



Similarly, the deficit on the current account of the balance of payments had also reached a very high level by 2009 (Chart 3). This made Greece extremely vulnerable to an abrupt interruption of the inherently volatile portfolio inflows from abroad, which up to that point had financed this deficit as well as a large part of the gap in the government’s budgetary accounts.




Proximate and Underlying Causes of the Crisis

The most important factor responsible for the crisis was the progressive loss of fiscal discipline (Chart 4). Greece did not have to “cook the books” to qualify for euro area entry. It did in fact make a determined effort to put its fiscal house in order and successfully met the public deficit criterion envisaged in the Maastricht Treaty (3%) when the decision was taken (in June 2000 on the basis of data for 1999). But almost as soon as this decision was announced fiscal policy was eased and  the budget deficit started rising again. This continued almost without interruption in subsequent years, culminating a fiscal mess in 2008 and 2009. Irresponsible fiscal policy was not only a violation of the euro area’s fiscal rules but it was also an extremely misguided policy, totally out of line with Greece’s immediate and medium-term economic interests.




The economic consequences of undisciplined fiscal policies were exacerbated by two unintended side effects of the adoption of the common currency. 


First, entry into the euro area led to a dramatic improvement in access to the international capital markets not only by the Government but also by the private sector at interest rates almost as low as those enjoyed by Germany. The banks took advantage of this access to finance a sharp expansion of credit to the private sector (Chart 5).


The second unintended side effect made it easy for Greeks to compare their incomes with those enjoyed by their counterparts in the more prosperous countries of the euro area. This fuelled wage demands and, given little resistance by employers and the laxity of fiscal and monetary conditions, it led to excessive wage increases (Chart 6) and a substantial erosion of the international competitive position of the Greek economy which shows the path of Relative Unit Labour Costs (RULC) (Chart 7).




The combination of fiscal laxity, overly rapid credit expansion and excessive wage increases contributed to a huge expansion in domestic spending. Between 2000 and 2008 domestic spending grew at an average annual rate of 7%, which exceeded by a large margin the long-run capacity of the Greek economy to grow. The surge in spending led to a short-term boom in economic activity. For several years Greece was one of the fastest growing members of the euro zone and the per capita income gap with the more advanced members of the area narrowed markedly. But inevitably the overspending also exacerbated inflationary pressures in Greece and the deficit in the balance of payments accounts, making Greece increasingly vulnerable to a shift in market sentiment or any other unfavorable external shock.  By 2009 a financial crisis in Greece had become in effect “an accident waiting to happen”.


The global financial and economic crisis that broke out following the collapse of Lehman Brothers did not cause Greece’s economic problems. There were some more fundamental weaknesses both in Greece itself and in the international environment within which Greece functions.


First and foremost among these weaknesses was the poor, irresponsible governance in Greece. The governments that were in power in Greece since its entry into the euro area failed to grasp fully the critical importance of disciplined fiscal policies, especially for a country that does not have the option of using monetary instruments to manage aggregate demand in its economy or to respond to exogenous shocks. They repeatedly missed golden opportunities during the boom years to restore a strong fiscal position which would have helped moderate the strong stimulus to domestic spending and economic activity emanating from the dramatic easing of monetary conditions associated with the introduction of the new currency. It would also have created some “fiscal space” that could have been used later on to counter the deflationary effects of the later Great Recession.


Instead, governments wasted the substantial dividends to the public revenue resulting from high growth and the reduction in the cost of servicing the public debt and pursued inappropriate policies that expanded the inefficient public sector. Such policies included:


  • the appointment in key positions of unqualified partisan friends rather than competent career bureaucrats demoralizing conscientious career civil servants and undermining the effectiveness of civil service institutions.

  • the extension to powerful groups of extravagant benefits, without regard to cost. Funding these benefits required excessive borrowing and high payroll tax rates. This reduced incentives for tax compliance, stimulated the growth of the black economy and raised the cost of doing business in Greece.

  • the creation of a multitude of public sector entities, some set up mainly for the sake of accommodating party friends (or even family members). Other potentially useful institutions were institutions that, given its current stage of development, the country could not afford such as hospitals.

Greek governments can also be blamed for a dismal record in promoting necessary structural reforms, including those envisaged under the Lisbon agenda. This contributed to the country’s poor ranking in various indicators of international competitiveness and discouraged investment, notably in export-oriented activities.


The second fundamental weakness responsible for the crisis was the inability of euro area institutions to enforce fiscal discipline, recognized as a necessary condition for its smooth functioning. The credibility of the Stability & Growth Pact (SGP), which spelled out the rules that countries had to observe for maintaining fiscal discipline, was seriously undermined when for political reasons the European Council failed to apply its provisions to Germany and France, the first countries to breach the SGP budget deficit ceiling. European institutions could warn member countries about the risks of lax fiscal policies, but none had the power or the requisite tools to enforce observance of the rules.


Thirdly, a fundamental factor which contributed to the severity of the crisis was the fact that the international capital markets are shortsighted and poorly regulated. For nearly a decade the markets paid little attention to the fact that Greece (and to a lesser extent other euro area countries) were busy building unsustainable imbalances. (See Sturgess, World Economics 2010)[1] This delayed the introduction of corrective action. Moreover, when the markets woke up, they overreacted in a typical fashion making the containment and resolution of the crisis all the more difficult.


Regulators, were at best passive observers of the destabilizing market behavior. The prevailing philosophy over the last 20 or 30 years had been that markets are able to regulate themselves. The tendency was therefore to deregulate rather than tighten regulation, but t even when it became clear that this philosophy does not hold in practice, little has been done to improve regulation and oversight. This may be attributed in part to understandable concern that tightening regulation at a time when the global economy has not yet fully recovered from the Great Recession may not be helpful but it also indicates that financial markets and conglomerates, especially those based in Wall Street and the City of London, still exert too much influence over the political decision-making bodies.



Efforts to address the crisis.

In early 2010 the spreads on Greek government bonds rose dramatically and it became clear that Greece would be unable not only to raise any new money in the international capital markets but even to roll over maturing debt. The cost of market access became prohibitively high.


After long delays, in part due to the reluctance of euro area leaders to involve the IMF, the Greek Government decided to seek official financial assistance to avoid imminent default. A package of measures was quickly put together and this was supported by exceptionally large financial resources by both the euro zone and the IMF. The package included a gradual, but nevertheless very painful, program of fiscal consolidation and a set of very ambitious structural reforms. Its stated aims were to reduce steadily the twin imbalances that Greece was experiencing, to safeguard the stability of the banking system, to improve competitiveness and the business climate so that growth could be gradually resumed, and to ensure that Greece would be able to return to the markets rather quickly[2].


The May 2010 adjustment program has produced some significant positive results, including a major reform of the pension system, a large reduction in the (primary) public deficit (8 % of GDP, of which 5% in the first year) and a partial recovery of external competitiveness. However, the recession turned out to be far deeper and more protracted than foreseen and  little progress has been made in implementing structural reforms. It became increasingly clear that debt sustainability would not be achieved. In fact, the debt dynamics worsened markedly during the program.


After protracted negotiations, a new rescue package was adopted in February 2012 which was built on the recognition that a return to market borrowing will be delayed for a long time. It provides for a significant involvement of the private sector in the resolution of the crisis. This is achieved through a “voluntary” debt exchange that entails a large nominal haircut of the privately held Greek government debt and highly concessional interest rates as well as long maturities on the new government bonds, including a 10-year grace period. All in all, privately held debt is reduced by almost 75% in Net Present Value (NPV) terms, implying that the debt restructuring that Greece has obtained is the largest ever recorded.[3]


The new package also increases considerably the amount of official financing available to Greece, with a substantial part set aside to rescue Greek banks and to make the debt exchange attractive to the private sector. On the policy front, the package extends the fiscal adjustment period by one year (with a primary fiscal balance to be achieved in 2013 rather than 2012 as envisaged initially), it eschews any further increases in tax rates and shifts the emphasis onto structural reforms, notably in the labor market, with a view to speeding up the restoration of external competitiveness.


The new program temporarily reduced pressures in international financial markets, but it is unlikely to put public finances on a sound footing and reverse the downward trend in economic activity. The pain for the Greek population is far from over, the challenges confronting the authorities remain daunting and the risks of derailment are not negligible.     



Why is the recession so deep?

The economic downturn in in Greece which began in 2008 in the wake of the global financial crisis was initially comparatively mild. However, it accelerated perceptibly in the course of 2009 and gathered additional momentum in the subsequent three years. The cumulative fall in real GDP in the five years to 2012 is estimated to be on the order of 17%, exceeding by a large margin the decline in output experienced by the other countries affected by the crisis (charts 8 & 9).   



The main reason for the depth of the Greek recession is related to the fact that the imbalance in the fiscal accounts had been allowed to become too large. The correction of this imbalance became inevitable when Greece lost access to the international capital markets, with the pace of the correction dictated entirely by the amount of official financial resources made available. Budget deficit can be reduced either through tax increases or expenditure cuts, but both lower domestic spending directly, or indirectly. The reduction in domestic spending, in turn, has a powerful negative effect on economic activity and thus on tax revenues, the more so because the Greek economy is inward looking (in contrast e.g. to the economy of Ireland), Since the financing of the budget cannot be increased, if the drop in tax revenues exceeds initial projections it has to be offset by additional austerity measures, with further negative (2nd round) effects on domestic spending and economic activity. The only factors that can put a brake on this downward spiral in economic activity are a recovery in exports and/or a pick-up in FDI.


The adverse effects of fiscal consolidation on economic activity were aggravated by a significant tightening of liquidity conditions. This resulted from the interruption (and indeed partial reversal) of the capital inflows that Greece had experienced during the boom years and was exacerbated by a modest increase in government arrears to the private sector and large withdrawals of bank deposits by Greek residents. Domestic banks have lost about 30% of their deposits over the past two years, a development which inevitably forced them to liquidate profitable investments in neighboring countries and to tighten their lending policies. As a result, credit to the private sector has recently been on a downward trend. It is worth noting however that a severe credit crunch has so far been avoided as the banks’ access to the ECB refinancing facilities has allowed them to offset most of the impact of deposit withdrawals.


In addition to these two factors, economic activity in Greece was adversely affected by some problems that had to do with both the design and the implementation of the adjustment and reform program initiated in May 2010.


On the design side, the main shortcoming was the failure to recognize at an early stage that government debt had become unserviceable, and that therefore a major restructuring was urgently needed. In addition, the program placed excessive emphasis on increases in tax rates, rather than targeted cuts in government outlays, and on ad hoc measures (e.g. tax amnesties, or across the board cuts in public sector wages and social benefits), which apart from reducing domestic spending had a negative impact on incentives to invest and to work. Finally, the measures chosen failed to dispel the perception that the adjustment burden was not fairly distributed, in particular the perception that those primarily responsible for the crisis (i.e. the politicians and their inner circle) were much less affected by it than the ordinary Greeks in the street.


On the implementation side, a big problem was that many of the structural reforms, notably those intended to strengthen competitiveness and improve the business climate were delayed or not implemented at all. The result was that business and consumer confidence tended to deteriorate rather than improve and the recovery in exports, which would have moderated the impact of declining domestic spending, was less than had been hoped for. In addition, the international credibility of the country worsened and some potentially large FDI projects failed to materialize.


Weak program ownership and strong resistance to the program by organized groups and the population at large made the situation even worse. The government lacked the courage to explain to the population that the painful measures were necessary to restore conditions for better performance in the future. Instead it cultivated the impression that some of the toughest measures were not really necessary but imposed on Greece by unsympathetic foreigners. The effect was to undermine popular support for the adjustment effort, to poison relations with partner countries and to further erode confidence and credibility.


Finally, one should mention for the sake of completeness that the external environment was much less favorable than expected when the program was put in place.



Are there any better alternatives?

Two alternatives have been discussed extensively in Greece and abroad. A key component of both is a unilateral default by Greece on its entire public debt.  This would have two immediate effects:


  1. It would deprive Greece of the assistance that it has received from its euro area partners and (at least initially) from the IMF as well, which compensated in part for its loss of access to international capital markets; and
  2. It would lower the budget deficit since Greece would presumably stop making interest payments on its debt, which in 2009 amounted to about 5% of GDP. However, the default in itself would not have any impact on the other component of the deficit, the primary deficit, which in 2009 was equivalent to over 10% of GDP.  (Chart 10)



The first alternative, a default with Greece remaining within the euro zone,  would result in a much deeper recession than the one actually experienced and hence it was not in Greece’s interest to adopt, even if one assumes for the sake of the argument that it is technically and politically feasible. The reasons for this conclusion are as follows.


o    The first victims of a default would be the Greek banks and the pension funds which hold a substantial part of the Greek government debt. Without any support from its euro area partners the Greek government would be unable to rescue these entities. The banking system would therefore collapse and the pension funds would be forced to drastically reduce pensions


o    Since no financing would be available in the wake of a default the entire primary deficit would have to be eliminated right away, probably in a disorderly way. This would result de facto in austerity measures at least twice as painful as the ones implemented during the first year of the May 2010 rescue package.


o    Many foreign banks, notably in France and Germany, would also experience substantial losses in the event of a unilateral Greek default, probably requiring assistance from their governments to survive. This would rightly upset partner countries and would raise pressure for retaliation, e.g. through cuts in the structural & cohesion funds that Greece is still receiving from the European Union.


Even now that the primary deficit has been reduced significantly a unilateral default is not advantageous for Greece because it would deprive the Greek authorities of the money set aside under the 2nd rescue package for rescuing the Greek banks (about €50 billion) and would also require larger austerity measures than those envisaged under the package.


The 2nd alternative that has been proposed by some commentators would combine a unilateral default with a simultaneous exit of Greece from the euro area. In theory, this solution offers a few advantages.


o    It restores Greece’s ability to print money in order to finance both the budget deficit and the cost of recapitalizing the banking sector. Thus, it would obviate the need for the severe austerity which characterizes the approach chosen


o    It makes it possible for Greece to devalue its new currency relative to the euro in order to quickly restore competitiveness and promote exports and growth over the medium term.


o    It provides a boost to national pride as Greece would no longer have to comply with conditions set by foreign lenders and international supervisors. The last advantage is psychologically important, but the other advantages are more illusory than real


o    The logistics of introducing a new currency are formidable and time consuming.  Even a (false) rumor that such a solution is contemplated would generate a run on bank deposits that would force the Government to impose strict restrictions (if not a complete freeze) on deposit withdrawals and probably take over the entire banking system. Until the new money is put in circulation, hoarding of euros and capital flight would also be experienced creating extreme liquidity shortages in the economy, with strong negative effects on economic activity. Moreover, the imposition of tight exchange controls would become inevitable (notwithstanding their questionable effectiveness).


o    While printing money could finance the budget deficit, including the cost of bailing out the banking system, it would not help at all in financing the balance of payments deficit as no foreign agent would be willing to accept payment in the new currency or extend credit to a country that had just defaulted on its debt. Even in the unlikely event that the exchange controls would be fully successful in averting capital flight, the endemic shortage of foreign exchange associated with the large deficit on current international transactions would probably force the Government to introduce tight import controls (in violation of Greece’ s obligations as a member of the EU). Even essential imports such as oil and raw materials would have to be rationed, creating havoc in the economy and probably making it inevitable for Greece to leave not only the euro area but also the EU.


o    All in all, the fall in economic activity at least in the short run would be much steeper than under the cooperative solution that has been adopted.


o    In addition, the pressure on politicians to implement the fundamental institutional and policy reforms that Greece requires to regain competitiveness and establish conditions for sound growth over the medium term would be eased. As a result, the presumed medium term benefits of currency depreciation would probably never materialize, Greece would be condemned to a mediocre economic performance over time and the risk of hyperinflation would greatly increase.


o    Finally a Greek exit from the euro area would open a Pandora’s box, as it would immediately attract attention to other vulnerable countries in the area. This would greatly destabilize the euro area, increasing the risk of its breakdown and thus the risk of Greece becoming a totally isolated country economically and diplomatically.


This last consideration also makes it impractical to envisage a temporary exit of any country from the euro area to help it regain competitiveness. A monetary union cannot survive if members can go in and out as their individual situation dictates. This is why the adoption of the common currency is by the terms of the Treaty that created the monetary union irrevocable.



Some concluding observations

The main conclusion of this analysis is that Greece is paying a heavy price for the misguided fiscal policy it pursued during the boom years that followed its entry into the euro zone. This misguided policy is forcing the country to pursue a very painful adjustment while the recession is in full swing.


There is no obviously superior alternative to the current adjustment and reform program, which by attracting very generous support from euro area partners and the broader international community, allows the painful adjustment burden to be spread over a number of years.


This does not of course imply that the adjustment program was designed and implemented in the best possible way or that there is no room for improvement. Looking back, it would have been helpful if the adjustment effort had been initiated earlier and if the need for a debt restructuring had been recognized more promptly. This would have reduced perceptibly the need for fiscal contraction and hence the severity of the recession. A longer period of adjustment would also have been helpful although this might have required even greater financing from the official sector than the one actually extended to Greece


Looking forward, the cost of the adjustment would be reduced and a return to growth brought forward if the program is implemented much more vigorously than has been the case so far. Stronger ownership by the authorities and increased efforts to convince the population that the unavoidable sacrifices are shared fairly by all segments of society would reduce popular resistance to the program and boost confidence. Similarly, it would be useful to avoid ad hoc measures, such as e.g. tax amnesties, which do not address structural weaknesses and in fact exacerbate them by undermining tax compliance in the future. Instead, priority needs to be given to reforms that have the potential to stimulate exports and investment quickly (e.g. removal of cabotage, rapid absorption of ESPA funds, fast approval of investment projects, etc). Finally, new initiatives to support growth across Europe would ease the task that  Greece is confronted with in revitalizing its economy.


[1] Sturgess (2010) provides a detailed account of how public information was ignored by the markets and the rating agencies. See Sturgess, B.T. Greek Economic Statistics: A Decade of Deceit, World Economics, 11 (2), April-June, 67-99.

[2] For details of the May 2010 adjustment program see International Monetary Fund, Greece: Staff Report on Request for Stand-By Arrangement, Country Report No. 10/110

[3] Further details of the 2nd rescue package can be found inter alia in: IMF Survey, March 15, 2012: IMF Board approves Euro 28 billion Loan for Greece,