Understanding the Greek Sovereign Debt Crisis

The Greek economy is plagued by twin deficits (government deficit and current account deficit) and has a debt crisis due to excessive consumption, rising borrowing, and inefficient public administration sector. The country's competitiveness has declined due to real wage appreciation and public sector employment growth, leading to a loss in exports and increase in current account deficit. Additionally, there are issues with tax evasion and corruption, which have contributed to the fiscal imbalance. To address these problems, structural changes must be implemented to promote entrepreneurship, innovation, and export-oriented production.

1. Introduction
The financial crisis that unfolded in mid-2008 led to a dramatic
increase of
public debt in many advanced economies. During that time we saw
transformation of the 2007 US subprime mortgage loan market
crisis into a sovereign debt crisis in the eurozone This overwhelming
increase in the public debt has been to some extent the outcome of
the effort by the governments to reduce the private debt that was
accumulated during the years preceding the recent financial crisis.
During the 2005-2007 economic boom there is an
average annual increase in private debt of the eurozone countries of
approximately 35% of GDP. In contrast during the years of economic
recession 2008-2009, private debt slowed down and public debt
growth accelerated.
The Greek debt crisis that began in late 2009 was followed by
respective fiscal and banking crisis in Ireland, Portugal, Spain and
Italy. The entry of Greece in the euro area and the adoption of euro
in 2001 gave to the economy a reduction in interest rates never
experienced before. Following the announcement of the Greek
government in 1994 that it intended to take the necessary steps to
fulfil the Maastricht criteria in order to bring Greece in the euro area
by 2001 the nominal interest rate on 10-year Greek government
bonds declined from about 20% to 31/2% in 2005. As the Greek
financial crisis erupted in late 2009, interest rates began to rise
substantially with the 10-year government bond yield increasing to
almost 27% at the beginning of November 2011 The adoption of the
euro gave several benefits to all its members, particularly to
countries like Greece with historical high levels of inflation and lack
of economic policy credibility. Thus, the introduction of the euro
supported by the monetary policy of the ECB led to a reduction of
inflation and inflation expectations in countries with high inflation
experience and thus reducing the uncertainty resulted by inflation
distortion. Furthermore, the low inflation environment and the
associated reduction in nominal interest rates, by increasing the
ability to borrow and lend at longer horizons,led to an increase in
private investment and robust real growth rates of 3.9 per cent per
year over the period 2001-2008. This high real growth rate was
stimulated by consumption spending, housing investment and
business investment. In addition, the adoption of the euro led to the
reduction of exchange-rate uncertainty and finally the reduction in
the nominal interest rates and risk premia led to the reduction of
the costs of servicing the public-sector debt and facilitating fiscal
adjustment leading to resource allocation to other uses. During the
period prior to the entry of Greece in the EMU the interest-rate
spreads between 10-year Greek and German government bonds

were reduced drastically from 11% in early 1998 to about 1% one
year before the entry. Following the entry in the eurozone the
spreads fell to 50 basis points whereas during the period 2002 until
the end of 2007 the spreads fell even further ranging from 10 to 30
base points.
Unfortunately, the Greek governments of the period 2001-2009 did
not take
advantage of the low inflation environment and they ran fiscal
deficits of 6 per cent of GDP on the average while they also
increased the share of the government spending in the economy.
Thus, when the negative effects of the 2007-2009 financial turmoil
reached the eurozone and worries over the fiscal problems of
Greece and other European countries started to emerged then it
was made clear that two hidden problems of the Greek economy
remained unaddressed were brought to the surface emphatically
once again. The tranquil years of 2001-2009 have led the markets
to ignore these two fundamental problems of the Greek economy
and made the successive Greek governments to believe that the low
interest-rate environment would be a permanent feature of the
Greek economy. Their econometric evidence shows that the drastic
reduction in interest-rate spreads occurred over the 2001-2009
period were not justified by the country’s fundamentals. In contrast,
they detect an overshooting of the spreads relative to fundamentals
when the Greek financial crisis broke up.
2. Unsustainable Fiscal and External Imbalances
The financial crisis brought to the surface the two long time existing
macroeconomic imbalances and structural weakness of the Greek
economy. During the last three decades the Greek government has
run excessive budget deficits and have been rising as percentages
of the GDP whereas the government revenues as percentage of GDP
decline continuously during this period. Two features regarding
fiscal policy are worth noting: First, despite the robust growth rate
that the Greek economy experienced and the favourable
macroeconomic environment, the Greek governments were not
successful in reducing the budget deficits below 3% of GDP in line
with the requirements of the Stability and Growth Pact. As a result
of such fiscal easiness Greece was under fiscal control by EU since
2004 with a short break in 2007. The fiscal situation deteriorated
dramatically in 2008 and 2009; second, over the whole period fiscal
policy was pro-cyclical. Thus, expansionary fiscal policy was

mainly expenditure-driven rising at the end of 2009 to over 50% of
GDP. Economic agents formed optimistic expectations about future
income, which given the low interest rate environment, led to
further borrowing and thus consumption. During this period private
and government consumption reaches 90 percent of GDP the
highest rate compared to EU-27, USA, Japan and other developed
countries. Fiscal deficits and consequently increased public debt is a
feature of the Greek economy which dates back in the late 1970s
and its evolution is independent of the political regime. Up to 1980
public debt was only 25% of GDP and external borrowing was only
made for
investment purposes.
Then, when the socialist government came in power in 1981 this
picture changed completely since external borrowing was used to
boost consumption
in an effort to raise the living standard of Greeks. By the end of the
1980s the
debt/GDP ratios has reached 80 per cent. This upward trend
continued during the period of political turmoil of 1990-1993 and
the conservative government in office.The period 1994-1999
highlights a period of steady public debt to GDP ratio of 110% when
the new socialist government put in force a stabilization programme
in an effort to meet the Maastricht criteria. The years 1999-2004
marks a period of falling debt/GDP ratio attributed to the high
growth rate of the Greek economy. This falling trend continued with
the conservative government since growth stimulated by the major
infrastructure built required to support the hosting of the 2004
Athens Olympic Games and additional financial flows transferred
from the E.U. The last period of
sample beginning 2007 showed a dramatic increase in borrowing
that resulted to a rise of the debt to GDP ratio to 130%. However,
given that when joining the eurozone Greece gave up the conduct of
monetary and exchange rate we would expect that fiscal policy
would be counter-cyclical in nature in order to act as automatic
stabilizer in the presence of country-specific shock.
Therefore, the pro-cyclicality of the fiscal policy could be considered
as a major source of shocks. The lack of competitiveness of the
Greek economy is an even more acute problem. This is a chronic
problem that dates back to the 1970s. The loss in competitiveness is
reflected in the huge current account deficit. During the period 2001
to 2009 both inflation and wages increases, adjusted for
productivity changes exceeded the average increases in the rest of

the euro area. During this period competitiveness, as measured by
consumer prices, declined by 20% while when measured by unit
labour costs, it declined by 25%. A more striking stylized fact was
the during this period wages appreciated in real terms by 5.5% in
the tradeables sector and by a huge 16.5% in the non-tradeables.
Therefore, it is clear that the adjustment
of international competitiveness of the Greek economy should
mainly come from internal devaluation in non-tradeables (given that
external devaluation is not an option) which will lead to a
reallocation of resources to tradeables resulting to an export-led
growth. The relatively high growth rates combined with falling
competitiveness led to an increase of the current account deficit
increased from 7% of GDP in 2001 to 14.5% of GDP in 2008. Finally,
the external debt of Greece rose from 94% in 2003 to approximately
200% at the end of 2010 which implies that the substantial interest
payments to foreign holders of Greek financial assets have led to a
deterioration of the income account deficit and thus the deficit of
current account.
The Greek economy’s imbalances are the most profound in the
eurozone
several other euro area countries, namely Ireland, Portugal, Spain
and currently Italy have experienced similar problems which are
also based on fiscal laxity and loss of international competitiveness
and in some cases as well as on problematic financial sectors. An
examination of the twin deficits relation for the eurozone reveals
that the fiscal imbalance is more important for the majority of the
countries-members. Greece and Portugal they have the largest
government deficits and current account deficits, but Ireland does
not suffer from either problem and Spain mainly suffers from loss in
competitiveness,
3. Public sector inefficiencies and low entrepreneurship
motives
There are several other features of the Greek economy that need to
be

discussed as they are related to the low productivity of the Greek
economy and the distortions that exist in the private sector which
over the last three decades led to a dramatic decline of the output
production of the manufacturing and industrial sector of the
economy. As we mentioned above, the real appreciation of wages in
the non-treadable sector (i.e. public sector, construction etc.)
coupled with a dramatic increase of public sector employees not
only in the General government but also in municipalities and public
welfare companies (which until very recently the Greek state held at
least 51% of the shares). Such a combination led to a reallocation of
capital and labour away from the private sector and especially from
export oriented sectors leading to the loss in competitiveness and
the increase in the current account deficit. The private sector was in
most cases tied closely with the public sector as most of business
contracts were in fact given by the government. This deteriorated
the competitiveness of the Greek economy since the private sector
learnt to depend mainly on government
projects of any kind and less on its efforts for research and
development, innovation of products and export oriented production
institutional
quality with an index value 80 well below the EU-16 average of 100.
It is also
interesting to note that the index of institutional quality deteriorated
steadily since 2006. Two additional facts for the Greek economy are
crucial in understanding the need for structural changes that must
be imposed if a sustainable growth must be achieved and the debt
repayment becomes sustainable as well. First, the crucial issue of
tax evasion as a result of the huge shadow economy. The tax
system as well as the overall attitude of certain professional groups
of the Greek society who systematically
avoid declaring their true income is one of the main sources of the
fiscal deficits. Based on the answers of the people questioned it is
shown that the positive answers on the questions “Entrepreneurs
think only about their wallet” and “Entrepreneur exploit other
people’s work” were more than those given in communist China.
This negative attitude can be partially attributed to the political
parties either conservative or socialists over the last thirty years
which by increasing the size of the public sector and the high wage
level they offered to the government employees relatively to the
private sector made the average person to search for a job in the
public sector where payment is not linked to productivity. A political
system operating on a trade off of vote for jobs has made severe
damage on the competitiveness of the Greek economy.

Further evidence based on the World Bank indices show that a high
degree of
difficulty for entrepreneurs to start up their business due to
bureaucratic obstacles that further inflate corruption (Greece is
ranked 109th among all countries). However, as we already
explained the private sector has its share of blame in this negative
situation. The public evidence is that Greece is by far the country
that during the 1995-2005 period experienced the highest growth
increase in public spending and publicl administration employment
which resulted to a gigantic inefficient public sector
4. Summary and concluding remarks
The Greek sovereign debt crisis is expected to have far reaching
implications
for the mechanisms of the eurozone as well as for the European
Union. Over
consumption financed by increasing borrowing over the 1980-2009
period, current account deficits and government budget deficits are
the main sources of the current dramatic state of affairs of the
Greek economy. This downturn in the Greek economy was further
fuelled by an extremely large and inefficient public administration
sector The current debt crisis has shown that a reform of current EU
mechanisms must be put in force, otherwise the stability of the
eurozone will be jeopardised and the euro currency itself will be
negatively affected.