Understanding the Greek Sovereign Debt Crisis


Added on  2019-09-26

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1. IntroductionThe financial crisis that unfolded in mid-2008 led to a dramatic increase ofpublic debt in many advanced economies. During that time we sawtransformation of the 2007 US subprime mortgage loan market crisis into a sovereign debt crisis in the eurozoneThis 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 anaverage annual increase in private debt of the eurozone countries ofapproximately 35% of GDP. In contrast during the years of economicrecession 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 areaby 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 theeuro 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
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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 takeadvantage 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 lowinterest-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 fundamentalswhen the Greek financial crisis broke up.2. Unsustainable Fiscal and External ImbalancesThe financial crisis brought to the surface the two long time existingmacroeconomic 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 GDPdecline 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
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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 afeature 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 forinvestment purposes. Then, when the socialist government came in power in 1981 this picture changed completely since external borrowing was used to boost consumptionin an effort to raise the living standard of Greeks. By the end of the 1980s thedebt/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 programmein 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 ofsample 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 ofmonetary 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 isreflected in the huge current account deficit. During the period 2001to 2009 both inflation and wages increases, adjusted for productivity changes exceeded the average increases in the rest of
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