Behind the Sovereign Debt Crisis in Greece

May 4, 2010

By Shiv Sethi, Sanhati

Introduction

The recent crisis in Greece is the new addition to the long list of casualties of the global financial and economic
crisis that started in 2007. It has called into question financial institutions as diverse as the public accounting
system to the common currency policy of the Euro zone.

In October 2009, the newly-elected government of Greece revealed that the country’s budget deficit was far
higher than previously thought: more than 12% as opposed to less than 3%, as required for membership in the
EU. Ever since, the deficit has been revised upwards and currently hovers around 13.6%. In addition, the
sovereign debt of Greece is nearly 400 billion dollars, close to 120% of its GDP and it runs a current account
deficit of nearly 14% in the Euro zone. These data together strongly imply that Greece has invested more than it
saved (i.e.,private and public sector savings taken together), supporting this extra investment by borrowing from
the rest of the world. In short, Greece appears to have lived beyond its means.

International finance has responded to this situation by downgrading its outlook of the public finances of
Greece. The Credit Default Swap (CDS) spread on Greece government bonds (which gives the financial
markets’ perception of the possibility of default on its debt by the Greek government) has sharply increased in
the recent past as the rating of these bonds was continuously degraded by agencies. In the past fortnight, the
bonds were relegated by a rating agency to the status of “junk” bonds.

In less than six month, the interest payable on these bonds has climbed from less than 4% to more than 15%.
Greece certainly cannot afford to borrow at such prohibitive rates. Being a Euro zone country Greece doesn’t
have the choice of treating its internal and external crisis separately: Greece can’t print currency for deficit
financing at home and devalue its currency to attempt to regain export competitiveness. In these conditions, its
only choice appears to be to appeal for a bail-out from the EU and/or IMF.

If the business press is to the believed, the only long term solution for Greece is almost crippling austerity.
Greece must cut on public expenditure to pay debts, import less and export more, sharply reduce wages and
other benefits such as pension, social security, and increase taxes like VAT.

Almost by implication, the business press advocates further privatization of the economy, cutting taxes for
businesses to spur investment, and to weaken the process of collective bargaining so as to allow businesses to
gain the upper hand in the “hiring and firing” process, what is sometimes euphemistically called flexibility of
labour markets. And this is being proposed at a time when the Greek economy is yet to recover from financial
crisis of 2007 and its GDP is shrinking.

Greece and the Euro zone

In a recent report published by Research on Money and Finance, a network of political economists working on
financial issues, the authors trace the recent travails of Greece to the formation of the common currency Euro
zone in 2001. Greece, along with other countries like Portugal and Spain, entered the Euro zone with an over-
valued currency, which compromised their export competitiveness. Ever since 2001, the export performance of
these countries has worsened.
Germany, the most powerful country in the Euro zone, has gained at the expense of these countries. In the past
10 years, the German economy barely grew at 2% per annum, local investment and consumption remained flat
and the productivity and real compensation of labour stagnated. On all these counts the countries of South
Europe did much better. However, Germany improved its export performance with respect to these Southern
countries. Since 2001, the average real compensation of a Greek worker increased nearly 25% more than in
Germany. This means that Greek exports are expected to cost at least 25% more than German exports. The
entire growth of German economy in this period is predicated on running large trade surpluses with the Euro
zone countries. As German local investment or consumption hasn’t increased, most of earned export surplus has
been recycled to Euro zone countries either as investment or mostly as debt.

This picture is borne out by the current and financial accounts of the Euro zone: Germany’s current account
surplus roughly equals the combined deficits of Greece, Spain, Portugal, and Ireland. And its total bank lending
in the region (a sum of FDI, portfolio investment and debt) explains the borrowing of these countries.

Thus, it is clear that, to a large extent, the recent economic crisis in Greece (and the the European “periphery” in
general) owes its existence to imbalances inherent in the common currency zone.

The need and the cost of the bail-out

As noted above, the main purported reasons of the crisis in Greece are its excessive government debt and the
budget deficit.

Before going further, one should compare these numbers with other countries. The average EU government
debt is roughly 80% of the GDP. The government debt of the UK exceeds 100%. Many countries are running
budget deficit above 9%. Most of these liabilities were incurred to bail out the large banks and financial
institutions in the aftermath of the financial crisis of 2007.

One of the topics singularly missing from the business press’s drumming of Greek ineptitude is the extent of
debt Greek government incurred to save its own banks. Even so, Greece is not doing too badly if compared to
the rest of the EU. It should be borne in mind that the European Central Bank (ECB) also lent hundreds of
billions of Euros to save these banks (euphemistically called “quantitative easing”. It means that the ECB
simply printed this money and loaned it to the bank). The bank bailout in the EU zone totalled at least a few
trillion Euros. In comparison, Greece requires less than 20 billion Euros to meet its current debt obligations.

One of the reasons offered, most notably by Greek politicians to their own people, to agreeing to a deal with the
EU and the IMF is to save the common currency of the EU. Indeed, the Euro has weakened with respect to
other currencies in the aftermath of the Greek crisis. Again the political underpinning of this seemingly
innocuous market mechanism should be noted: there was no such attack on Euro by international finance when
the ECB was printing hundreds of billions of Euros to bail out banks. Somehow these financiers are more
interested in a 20 billion Euro shortfall in Greek’s debt repayment than the enormous amount lent as bank bail-
outs.

One of the features of all the Euro zone countries after 2001 is the fall in the share of wages (income of the
working class) in GDP. In all the countries, the productivity of the labour has increased at a sharper rate than the
real compensation. One of the favourite criticisms of the business press of the Greek government is its inability
to keep workers on leash. They point to the increase in the real wages of Greek workers as a source of the
current problem. In fact, real wages
have increased barely 30% since 2001, and the ratio of the wages to productivity remains largely unchanged.
The bail-out of Greece by EU and the IMF will further aggravate this trend. The conditions of bail-out require
Greece, inter alia, to drastically reduce government spending to bring down the budget deficit from nearly
13.5% to less than 3%.

Since the 1930s, large government expenditures, accompanied by budget deficits, are known to be vital to the
running of capitalist economies. This spending acts to keep aggregate demand at a level that makes private
investment viable. This should be borne in mind while calculating the cost of cut backs on government
spending.

Greek government expenditure is nearly 50% of the GDP. If the Greek government cuts its budget by 10%, it
reduces the total spending by 5% of the GDP. Generally the direct spending by the government, as opposed to
running deficits by tax breaks to businesses, generates larger secondary income in the economy. In other words,
5% of the GDP generates an income far exceeding the initial spending, depending on the pattern of
consumption and saving in the economy. If this factor is assumed to be between 2 and 3, then a cut-back of 5%
will contract aggregate income approaching about 10-15% of current GDP. This will increase the already high
unemployment rate in Greece to unprecedented highs: by some calculations, the official unemployment rate will
reach levels seen in the US during the Great Depression.

The main objection to this argument runs as follows: when government withdraws the private sector takes over.
However, the austerity measures being imposed on Greece do not lack historic precedence. These measures
were called Structural Adjustment Programs (SAP) barely 20 years ago. The SAPs were imposed by the IMF on
nearly 100 developing countries through the last two decades of the 20th century, as part of the conditionality to
obtain emergency funds to ward off their balance of payment crisis. There are hardly any cases where the
professed aims of the SAPs were realized. In most cases, the crisis recurred and deepened. Even the few
countries that managed a decent GDP growth achieved it at the cost of great income inequality, stagnant or
falling wages, and mostly at the cost of some other country.

If the recent history is any guide to the future, the working class in Greece faces a long and bleak future in the
aftermath of the bail-out and hopefully will fight to stave it off.

Greece crisis and the consequences for India

If the Greek crisis spirals into a larger European sovereign debt crisis and possible fragmentation of the
eurozone, India's [ Images ] trade and capital flows could be hit, says Shankar
Acharya.

Back in January, during a discussion with this paper's editorial brains trust, I had
mildly suggested an edit on the emerging Greek budget problems and its wider
consequences.
This was greeted with indulgent smiles and suppressed mirth of the kind usually reserved for doddering uncles.
Which reader would be interested in the fiscal predicament of a small and distant European nation?

Some four months later, I confess to a feeling of vindication. Greece's public finance problems have ballooned
into a major European crisis with global ramifications. The evolution of the crisis has accelerated over the last
fortnight and sent world financial markets into a tizzy.

Today, Greece is in a bad place. Its GDP fell by 3 per cent in 2009 and is expected to drop another 4 per cent
this year. Its fiscal deficit of 13.6 per cent of GDP in 2009 is slated to be brutally chopped to 3 per cent of GDP
by 2014 under the huge euro 110 billion EU-IMF bailout programme agreed early last week.

Despite such extraordinary fiscal compression, Greece's towering 115 per cent ratio of government debt to GDP
is expected to climb to nearly 150 per cent in three years.

GDP is expected to contract a further 5 per cent by then. As Martin Wolf has pointed out (Financial Times, May
5), even if everything goes according to plan, in 2014 Greece will be having to run a 4.5 per cent of GDP
primary fiscal surplus to service the 7.5 per cent of GDP of interest payments on its government debt.

Will Greeks put up with the deep and sustained cuts in public wages and pensions, and massive hikes in taxes
that all this entails?

Commentators (and markets) are sceptical. They point out that if Greece had faced a similar problem 12 years
ago, the obvious solution would have included devaluation of the drachma and a restructuring of the debt (an
euphemism for organised, partial default).

Today, being a member of the eurozone rules out devaluation. And debt restructuring for Greece would fan the
flames of contagion that are already warming Portugal, Ireland, Spain and Italy [ Images ] (the other PIGS).

Herein lies the rub. Greece is missing crucial options for adjustment because she is an eurozone member.
Conversely, the likely political and economic infeasibility of Greece's harsh fiscal compression programme is
damaging Europe by sustaining the threat of contagion and calling the entire single-currency experiment of the
euro into question.

And this is why the travails of little Greece (with GDP equal to about one-fortieth of the European economy)
are plaguing the European Union, still the largest single economic entity in the world.

A dozen years ago, many had doubted that a monetary union could be sustained without a fiscal union.
Analysts, such as Paul Krugman, have pointed out that California's major fiscal problems are containable
precisely because US federal fiscal policy cushions their impact on both Californians and the rest of the US.
The euro-sceptics are waxing eloquent today.

How will all this pan out? The honest truth is that nobody really knows. The crisis is still unfolding. And fast.

Recall that hardly three weeks ago, Europeans were still negotiating over a euro 45 billion bailout package for
Greece. Months of dithering by Germany [ Images ] and others helped catalyse the recent downgrades by credit
rating agencies, which amplified the Greek problem and its contagion potential, and nearly tripled the scale of
the final package.
That didn't prevent international financial markets and the euro from plunging towards the end of last week,
triggering a weekend of frenetic activity among European leaders, with stiff doses of advice injected by the
Obama [ Images ] administration.

The result was the announcement on Monday, May 10, morning of the mammoth euro 750 billion EU-IMF
standby, bailout package of loans and guarantees plus the European Central Bank's (ECB's) arm-twisted
readiness to purchase European debt for quantitative easing.

After an initial, reassuring bounce, international markets again turned jittery on Tuesday, underscoring the
continuing doubts about a lasting resolution of the fiscal-debt problems of Greece and other PIGS.

There is a chance that the Greek polity will accept the fiscal compression demanded. It's possible that contagion
(much of it irrational and fuelled by financial herd behaviour) will be contained through wise, anticipatory
policy by the governments of Spain, Italy, Portugal and Ireland, and adroit actions by ECB and the European
Union.

In that case, just maybe, European recovery from the Great Recession will simply stutter a bit in 2010 and then
resume the positive trajectory outlined by the IMF's World Economic Outlook of late April.

The problem is that such wisdom and courage, if shown, will need to be sustained. And the track record, thus
far, is not wholly reassuring.

Thoughtful analysts believe that there is a better than even chance that something major will go wrong in the
many weeks and months of fiscal and financial stress that lie ahead for Europe. Then the unthinkable might
happen: Greece could leave the eurozone or default or both.

In that case, contagion could spread across Europe and undermine otherwise healthy economies. No realistic
estimate can be made presently of the pan-European and global consequences of such events.

But the continuing turbulence in financial markets worldwide suggests that people are thinking about the
unthinkable and its consequences.

What are the possible consequences for India? It's too early to tell but one can speculate. If the crisis is
successfully contained and European recovery resumes, then there may be no significant external trade shock to
India.

With more money sloshing around in international markets, capital inflows into India will grow and exacerbate
the already big problem of a substantially overvalued rupee. Oil prices will resume their upward march and
magnify India's petroleum subsidies and fiscal stresses.

At some point, perhaps quite a few months later, the unsustainability of India's fiscal, debt and external current
accounts will come home to roost.

On the other hand, if the Greek crisis spirals into a larger European sovereign debt crisis and possible
fragmentation of the eurozone, then global trade and capital flows will be badly hit.

How badly and how much this will hurt India is impossible to assess at present. The only silver lining could be
a drop in international oil prices, implying a lower oil import bill and reduced petroleum subsidies for India.
Either way, macroeconomic policy will be exceptionally challenging in the months ahead. Let's hope the
ministries and institutions responsible for the conduct of India's macroeconomic management can summon the
requisite competence and will.

The author is honorary professor at ICRIER and former chief economic adviser to the Government of
India. The views expressed are personal.