Reflections on the Crisis in Greece
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.
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
- 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.
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:
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
The negotiation of a new Pact
to strengthen fiscal discipline in the euro area (and the EU more broadly)
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.
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.
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.
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.
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.
economic consequences of undisciplined fiscal policies were exacerbated by two
unintended side effects of the adoption of the common currency.
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
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).
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”.
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.
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
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
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.
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
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.
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
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.
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
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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:
- 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
- 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
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.
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
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.
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.
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.
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.
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
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.
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
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
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.
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.
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.
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.
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.
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.
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.
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
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.
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