National and Kapodistrian University of Athens Department of Economics

UADPhilEconGlobal Imbalances

Greece’s Debt Crisis: Overview, Policy Responses and Implications

Rebecca M. Nelson, Paul Belkin, Derek E. Mix

Congressional Research Service, August 18, 2011

Student:Droulia Eleni

Introduction

Causes of Greek crisis

Policy responses to crisis 1st – May 2010 2nd – June & July 2011

Broader implications on EU

Impact on US economy

Structure of Paper

2000s Greece had abundant access to cheap capital but didn’t use it to increase the competitiveness of the economy.

2008-9 Global financial crisis2010 Greece risked defaulting on its public debt

Major financial assistance package2011 Greece veered again towards default

Second package of measures

Introduction

Causes of Crisis

Real Reasons Pervasive state control of the economy

(State controlled 75% of all business assets - 1990 and 50% - 2008) Large and inefficient public administration

(2009 – Government expenditures were 50% of GDP and 75% of this went for public sector wages and social benefits)

Endemic tax evasion (complex tax code that grants exceptions to numerous professions and income brackets)

Political Clientelism(Clientelism is behind pervasive tax evasion, generous wage and pensions and corruption)

Causes of Crisis

Motives Influx of capital at low interest rates during 2000s. Global Financial Crisis of 2008-2009.

More specifically: During 1990s borrowing costs dropped dramatically. Interest rates on 10-year Greek bonds were dropped by 18%

between 1993 and 1999. Entrance on Eurozone increased investor’s confidence.

Cheap credit paid for government spending and low tax revenue and not to productive investment and State borrowed for imports.

Government budget and trade deficit ballooned during 2000s

Twin Deficits

Causes of Crisis

Causes of Crisis

2008-2009: Global Financial Crisis

2009: Investor’s confidence in Greece’s ability to service its debt dropped significantly.

Greece’s reported public debt rose from 106% of GDP in 2006 to 126% in 2009.

2009: New Government, led by George Papandreou, revealed that previous Greek governments had under-reported the budget deficit.

Greek bonds were rated downgrades by major credit rating agencies.

Investors asked for higher interest rates for buying and holding Greek bonds.

Causes of Crisis

Causes of Crisis

Higher interest rates compensated investors for the higher risk involved in holding Greek bonds, but also raised borrowing costs, and caused Greece to veer towards default.

Policy Responses to Crisis

In order to avoid an uncontrolled, disorderly default Eurozone and IMF offered a financial assistance the May of 2010 paired with austerity measures and reforms.

Eurozone €80 billion A three-year package of €110 billion

IMF €30 billion Disbursement of funds was made conditional on implementation of

economic reforms.

May 2010 : a new European temporal mechanism was created for providing financial assistance to Eurozone members. It was a three-year lending facility that could loan totaling €500 billion.

March 2011 : European Stability Mechanism was founded and it was a permanent lending facility to replace temporal assistant.

1st Policy Response - May 2010

Austerity Program aimed to reduce government’s budget deficit by 11% through 2013, bringing it below 3% of GDP 2014.

Program included: Government spending cuts to civil service

Reduction or freeze on civil service compensation (July 2010 – average retirement age increased) Freeze civil hiring

Government revenue rise Rise of average value-added tax rate Increased taxes on certain commodities (fuel, tobacco, alcohol) Strengthened tax collection Higher contribution requirements for tax evaders

ECB purchased government bonds until June 2011 totaling €78 billion to increase confidence.

ECB supports also Greek Banks with “liquid” first with €47 billion in January 2010, amount which increased to €98 billion May 2011.

1st Policy Response - May 2010

Spring of 2011: Medium-term Fiscal strategy, which was a consolidation program through 2015 worth €28 billion.

Aims of program: Reduce over-staffing pubic sector Improve the financial performance of state-owned enterprises Streamline of social transfers Privatization and public real estate development program Sale of public assets, which will be overseen by an independent

privatization authority composed by EU and IMF representatives July 2011: Second financial assistance package totaling €109 billion. IMF refrained from the second package. IIF – Institute for International Finance announced that holders of Greek

bonds would participate in a bond exchanges and bond rollovers (€37 billion) and debt buybacks (€12.6 billion) to lower Greek debt payments totaling €50 billion.

2nd Policy Response - June 2011

Policy responses have not been taken lightly, they have been reached only after months of negotiations.

But providing financial assistance to Greece has been controversial. Many Eurozone countries, including Germany, resisted to financial

support. IMF program for Greece was quite large relative to the size of the

economy and has not lent to developed countries last decades. Close to 50% of Greeks wanted parliament to reject new austerity

measures in June 2011, with only 35% in favor of parliamentary approval.

Evaluation on Policy Responses

Reasons of Limited Success Greece’s public debt increased between 2010 and 2011 from

143% of GDP to 166% of GDP. Most analysts agree that debt sustainability has hampered by

lack of growth. Growth was proved difficult because:

Austerity measures have depressed domestic sources of growth Greece cannot rely on exports for expanding economy As a member of Eurozone cannot depreciate its currency to help spur

exports Crisis’s measures have failed to protect Greece because:

May have exacerbated investor anxiety rather than reassured markets Crisis might be spread because of other Eurozone countries faced fiscal

challenges

Evaluation on Policy Responses

Broader Implications on EU

1. Greek policy responses set precedents how to handle debt crises like Ireland and Portugal.

2. Greece’s crisis has exacerbated concerns about the health of the fragile financial sector because European banks are holders of Greek bonds.

3. Debt crisis has created new financial liabilities for other European countries that have increased commitments to EFSF – European Financial Stability Facility.

Economic and Political Implications

4. Greek crisis has highlighted the policy constraints on members of the Eurozone. A new national currency could spur exports but also could trigger a worse financial crisis because a new devalued currency would increase the value of its debt in terms of national currency.

5. A broader re-examination of EU economic governance has been sparked in order to improve the long-term functioning and stability of the currency union. New legislations that promotes greater surveillance.

6. Debt crisis has posed challenges and opportunities for deeper EU integration.

Economic and Political Implications

Impact on US

There is a bilateral economic relationship between EU and US.

A loss of confidence in the euro:

Depreciation of euro relative to the US dollarLess demand for US exports to the Eurozone and increase US imports from Eurozone broaden US deficit Also a weaker euro can attract US capital to Eurozone

Impacts on US

Shows upward and downward swings in the euro-dollar exchange rate since May 2010.

Direct Exposure €7.3 billion (December 2010) Indirect / “Other potential exposures” €34.1 billion (December

2010)

derivative contracts, credit default swaps (CDS)

Exposure to Greece

Exposure to Eurozone

US banks are more heavily exposed to other Eurozone Countries.

Some believe: IMF program for Greece is unusual because: IMF has not generally lent to developed countries in recent decades Loan is unusually large compared to the size of Greek economy Resources were provided to a country that will not be able to repay its

debt Others: IMF program is not unusual:

Greece is a member of IMF The size of the loan is large but policy reforms required are also large

Legislation in July 2010: IMF oppose loans to high and middle income countries with large public

debt levels (greater than 100% of GDP) if it is not likely that they will repay the IMF.

IMF and US Legislation

The End