Greece Debt Crisis and Way Ahead

Greece Debt Crisis can be explained in one line as follows

 

A case of living beyond your means and using additional debt to finance existing interest payment. A cycle which can run as long as credit is cheap and available

Prerequisites

To understand what went wrong in Greece and why, it is first important to equip ourselves with some basic tools which are used to control an economy during its cycle through a boom and recession phase. We need to understand the inflationary gap and recessionary gap. We also need to have a basic knowledge of fiscal policy, monetary policy, exchange rate policy and structural policy. For understanding about the topics mentioned above, it is recommended to go through Economic Policy Series Article List.

Eurozone

Eurozone means a group of countries which have a single monetary authority called European Central Bank which regulates a common currency for the group called Euro. It consists of 19 countries of 28 countries of European Union. The countries such as Ireland, Portugal, Spain, France, Italy, Germany, Greece are part of it. The countries in Eurozone do not have an independent monetary policy or exchange rate policy as they have a single currency called Euro which is regulated by European Central Bank.

Greece Economy Problems

In short, following are the reason for present Greece problems:-

• Corruption
• Inefficient Bureaucracy
• Laws which make competition Illegal
• Bad Governance
• Tax Evasion
• Rigid labour laws

Economic History  of Greece

Europe Bond Yields

1. Before joining Eurozone in 2001

Before Greece joined Euro, it was a middle-income country with poor governance. Its domestic currency was Drachma. As you can see in the above graph that Greek govt. had to offer more than 10-15 % interest rate to borrow from the private investors in the financial bond market to finance the budget deficit. Greece had a very poor credit rating. Borrowing was hard for Greece Govt, so it promoted careful spending of debt.

2. After joining Eurozone and before financial Crisis of 2008

After the Greece joined Eurozone and adopted a common currency Euro. It found that now it can borrow at the same interest rate as Germany or France as Investor believed that being a part of Eurozone, Greece debt is same as Germany Debt or France Debt, so in case if Greece Govt is not able to pay than financially strong member of Eurozone such as Germany and France will pay.

Greece government used this opportunity of cheap credit to finance it huge government deficit to run its populist schemes and fared poorly on tax collection. Moreover, Greek Government fudged its account to show that its debt is below the official Eurozone member countries limit of 3% of GDP per year but actually it was around 13% of GDP. Greece even hosted 2004 Olympics on borrowed money. Moreover, Greece People who traditionally had to borrow at more than 10 – 15% interest now found the cheap availability of Credit, so they also went on spending spree to buy premium German Products such as Luxury Cars or Yachts. As a result, Greece imports increased. As a result, Greece became the fastest growing economy in the Eurozone. Look at the following increase in Per-Capita Income.

Greece Per-capita Income

No tax was paid to government from increased income. Look at following figure to understand, it states that Greece is not able to collect 89.5% of it tax revenue.

Greece Tax Inefficiency

3. After financial crisis of 2008

As you can see in the above graph that Greek recession is worse than United States Great Depression as Greek economy shrank by about 25% more than US economy in Great Depression. It occurred due to the following factors:

• US Sub-prime Montage Crisis: It caused the credit markets to collapse all over the world. As investor were worried about the payment of mortgage back. So now investor were reluctant to lend it to any country with a high debt to GDP ratio as they were worried about whether the particular government will be able to pay up its money. So boom due to cheap credit stopped.
• Manipulation of Greece Government Accounts: For long Greece Govt has manipulated it accounts to understate it debt to GDP ratio but when reports of its unsustainable debt were revealed to the market, Investor panicked and started selling Greece Govt Bond which forced Greece govt to pay higher interest rates to borrow in the market. Higher interest rate created a huge burden on the Greece. In fact today Greece debt to GDP ratio is 180% meaning that for every euro that greek economy earns it owes 1.8 euros to outsiders.

Greece Govt Debt Trend

European Countries Debt to GDP ratio

• Tourism Industry Hit: Tourism industry which constituted about 50% to Greek economy sharply declined after US Financial Crisis and due to turbulent conditions in the country due to Protest against Government austerity measures
• Government Austerity Measures: In Greece, Public sector is a major employer with about 25% of the total working population working under Greek Government. Infact two-thirds of the electorate is living partly or wholly on the government hand-outs. So any cut in government spending meant a huge negative multiplier effect on the economy.  In 2012, Greek Govt defaulted on payments to private Investors due to high-interest rate and high debt-GDP ratio. At this instant to keep Greece in Eurozone and to stop cascading effect of potential Grexit on other south European countries such as Portugal, Spain, Italy and Ireland, the troika, European Central Bank, IMP and European Central Bank bailed it out on the terms that Greek government would increase taxes and cut government spending.
• Investor Sentiment: Seeing such austerity protest in the country and instability of Greece remaining in the Eurozone, lead investor to avoid Greece to establish any new factory or production units
• Consumer Sentiments: Consumers anticipating bad times to come started saving more and spending less to prepare for worst future conditions. As a result, Aggregate demand in the economy fell down leading to a decrease in GDP. You can see in the following graphs about the quantum of decline in incomes of Greeks compared to 1970s standard and increase in unemployment in Greece

Greece Unemployment Ratio

• Decline in Bank Deposits: Greek people are fearing that due to non-payment of interest on Debt, Greece might exit Eurozone and adopt its own currency such as Drahma. This led to people to withdraw cash from Greek banks to keep them either in their home or in strong European countries such as France or Germany. As a result of the flight of capital from Southern European countries to Central European Countries, Greek banks are facing liquidity crunch as there are not able to pay bank deposits in Euros. With reduced capital at Greek Bank, they can’t in lend to borrowers to start any kind of new business or new transaction, so as a result economic business activities are dwindling.

Greece Bank Deposits

Way Ahead

Well to solve any kind of economic problem, the government has the option of using fiscal policy, monetary policy, exchange rate policy and structural policy. The root cause of all the Greece present debt problems is the fundamental problems in its economy which prevented competition with excessive anti-competition regulation and inhibited the growth of the private sector and in turn promoted corruption and rent-seeking. It has following two options:-

1. Remain in Eurozone

But with Greece being a member of Eurozone doesn’t have a separate currency so cannot pursue monetary policy or exchange rate policy. It is presently under high government debt so following the expansive fiscal policy is not even an option. The best thing that a Greece government can do to focus on Public Finance and Structural Reforms.

The austerity measures are aimed at increasing taxes and reducing spending so in turn following restrictive fiscal policy to contain govt. debt. It is because of this reckless government spending that Greece is in such situation. It should take measures to act against widespread tax evasion in the country. By this measures it should hope to bring its public finance in order

The Greece should follow structural reforms which are aimed at reducing the cost of doing business and increasing the ease of doing business with less bureaucratic regulation, liberal labour laws to increase cost-competitiveness. Then with following of Structural Reforms in the economy, Greece would be in long-term able to come out of the crisis. Structural reforms helped India to become one of the fastest growing economy in the world

2. Grexit

Grexit is not what a people in Greece want, as large as 70% of Greece population want to remain in Eurozone as they don’t think Euro is the problem but core problem is political system inefficiency and corruption.

If Greece exits from the Eurozone then it would have to adopt its own currency and then it had to devaluate it to make it exports and tourism industry look competitive. Devaluation of currency will reduce imports thus helping of balance of payments of Greek Government. Thus in the long-run Greek economy can hope to become competitive and recover.

But however with now bank deposits converted to Drachmas, Greeks will found their wealth in actual terms to decreased and Businesses will found it difficult to make payments in Euro loans that they have taken earlier. But surely in this scenario also, Structural Reforms can not be ignored.

Read More

• Greece’s debt crisis explained in charts and maps
• MostlyEconomics, Political economy of Greece crisis and why India did not go the Greece way?