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Greek Crisis in Perspective: Origins, Effects and Ways-Out, Nicos Christodoulakis - an extract

Breaking the cycle: Nicos Christodoulakis explains the Greek economic descent and what the country must do to recover.

In the aftermath of the global financial crisis of 2008, several European countries were engulfed in a spiral of rising public deficits and explosive borrowing costs that eventually drove them out of markets and into bail-out agreements with the International Monetary Fund (IMF), the European Union (EU) and the European Central Bank (ECB). Greece was by far the most perilous case, with a double-digit fiscal deficit, an accelerating public debt which in GDP terms was twice the Eurozone average, and an external deficit near US$5,000 per capita in 2008, one of the largest worldwide.

In the wake of an EU bailout and two elections the situation remains critical. Unemployment is rocketing, social unrest undermines the implementation of reforms and the fiscal front is not yet under control, despite extensive cuts in wages, salaries and pensions. The possibility of Greece exiting the Eurozone is widely anticipated.

Greece joined the European Union in 1980. Membership inspired confidence in political and institutional stability but fed uncertainties over the economy. After a long period of growth, Greece faced recession not only as a consequence of worldwide stagflation, but also because on its way to integration with the common market it had to dismantle its system of subsidies and tariffs. Soon after accession, many firms went out of business and unemployment rose for the first time in decades.

The government opted for fiscal expansion including underwriting ailing companies. The effect was predictable: a chronic haemorrhage of public funds without any supply-side improvements. Similarly, the expansion of demand simply led to more imports and higher prices. The external deficit approached 8% of GDP in 1985, a level at which several Latin American economies had collapsed. A stabilization programme in October 1985 involved a devaluation by 15%, a tough incomes policy and extensive cuts in public spending. The programme achieved a rise in revenues by beating tax-evasion practices and replacing less effective indirect taxes with the VAT system. Public debt was immediately stabilized, but the programme was opposed from within the government and was abandoned in 1988.

Despite looming deficits, in 1989 the coalition government decided to abolish prison sentences for tax arrears, which was taken as a signal of relaxed monitoring, thus effectively encouraging further evasion.

Another bizarre measure was to cut import duties for repatriates buying luxury cars, thus depriving the budget of badly needed revenues and leading to black-market abuses.

As a result, revenues collapsed and the country suffered a major fiscal crisis until a majority government elected in 1990 enacted a new stabilization programme.

Although Greece was a signatory of the Maastricht Treaty in 1991, it was far from obvious how or when the country could comply with the convergence criteria. Public deficits and inflation were at two-digit levels and there was great uncertainty about the viability of the managed exchange rate.

In May 1994, capital controls were lifted in compliance with European guidelines and this promoted fierce speculation. Interest rates rose sharply and the Central Bank of Greece exhausted most of its reserves to stave off speculation. This proved to be an incentive to join the European Monetary Union to ward off more attacks. Soon after the 'Convergence Program' set time limits to satisfy the Maastricht criteria and included a battery of reforms in the banking and the public sectors.

However, international markets continued to doubt exchange rate viability. With the advent of the Asian crisis in 1997 spreads rose dramatically and Greece finally chose to devalue in March 1998 by 12·5% and subsequently to enter the Exchange Rate Mechanism. The country was not ready to join the first round of Eurozone countries and was granted a transition to 1999 to comply with the convergence criteria.

After depreciation, credibility was enhanced by structural reforms and reduced state borrowing so that when the Russian crisis erupted in August 1998 the currency came under very little pressure. Public expenditure was kept below the peaks it had reached in the previous decade and was increasingly outpaced by the rising total revenues. Tax collection improved with the introduction of a scheme of minimum turnover on SMEs, eliminating a large number of tax allowances, by the imposition of a levy on valuable property and a reorganization of the auditing system. With the privatization of public companies, public debt fell to 93% of GDP in 1999. Although still higher than the 60% threshold required by the European Treaty, Greece was said to be on track 'to lean toward that level', a formula used by other countries to enter EMU.

Market reforms, introduced for the first time in 1986, aimed at modernizing the outmoded banking and financial system in compliance with European directives. A major reform in social security in 1992 curbed early retirement and excessively generous pension/income ratios.

Throughout the 1990s, reforms were aimed at restructuring public companies whose deficits had contributed to the fiscal crisis in 1989. State banks were privatized or merged, several outmoded organizations were closed down and initial public offerings (IPOs) provided capital and restructuring finance to several utilities. Other structural changes included the lifting of closed-shop practices in shipping, the entry of more players into the mobile telephone market and efforts to make the economic environment more conducive to entrepreneurship and employment.

After 2000, the reform process gradually slowed. Proceeds from privatization peaked in 1999, but subsequently remained low as a result of the contraction in capital markets after the dot.com bubble and the global recession in 2003.

An attempt in 2001 to reform the pension system led to social confrontation and was finally abandoned, to be replaced by a watered-down version a year later. Two other reforms followed in 2006 and 2010, but the social security system was still burdened by inequalities, inefficiencies and structural deficits.

Reform fatigue spread more widely after the Olympic Games in 2004. Since then, reforms have been concentrated on small-scale IPOs, with important exceptions being the sale of Greek Telecom and the privatization of the national air carrier.

Despite primary surpluses achieved throughout 1994-2002, public debt fell only slightly. There were three reasons. First, the government had to issue bonds to qualify for joining the Euro, a capital injection which led to an increase in public debt without affecting the deficit.

Second, after a military stand-off in the Aegean, Greece increased defence expenditure to well above 4% of GDP. In line with Eurostat rules, the burden was fully recorded in the debt statistics at the time of ordering, but only gradually in the current expenditure according to the actual delivery of equipment. This practice created a lag in the debt-deficit adjustment which was removed in 2004 when the government reverted to accounting at the date of ordering. Though a decision by Eurostat in 2006 made the delivery-based rule obligatory for all countries, Greece did not comply. The result was that deficits were augmented for 2000-04 and scaled back for 2005-06.

The third reason was the strong appreciation of the yen/euro exchange rate by more than 50% between 1999 and 2001, which increased Greek public debt on loans in the Japanese currency contracted during the 1994 crisis. To alleviate this, Greece entered a currency swap in 2001 by which the debt to GDP ratio was reduced by 1·4% in exchange for a rise in deficits by 0·15% of GDP in subsequent years, so that the overall fiscal position remained unchanged in present value terms. Although the transaction had no bearing on the statistics for 1999 on which EMU entry was assessed, critics mistook it as a ploy to circumvent a proper evaluation.

After the Eurozone became operational, hardly any attention was paid to current account imbalances of Greece or any other deficit country. It was only in the aftermath of the 2008 crisis that the European Union started emphasizing the adverse effects that external imbalances might have on the sustainability of the common currency.

The reason for this complacency was not merely that devaluations were ruled out by the common currency. A widespread view held that external imbalances were mostly demand-driven and, as such, they would sooner or later respond to fiscal adjustment. This proved to be misguided optimism.

The deterioration in the Greek current account accelerated after 2004 as domestic demand rose in the post-Olympics euphoria, inflation differentials with other Eurozone countries widened and the euro appreciated further. A similar erosion of competitiveness took place in all other European countries that are currently in bailout agreements (Ireland by 12% and Portugal by 8%) or considered to be at the risk of seeking one (Spain by 9% and Italy by 8%).

However, Greece was particularly vulnerable. Accelerating labour costs, the poor quality of the regulatory framework, corruption practices and weak government were all crucial in shaping productivity and competitiveness. These factors explain the poor performance of Greece in attracting foreign direct investment in spite of the substantial fall in interest rates and capital flows within the Eurozone. While FDI remained almost static, its composition changed with inflows directed to non-manufacturing sectors, notably to real estate. Investments in real estate boost aggregate demand, raise prices, cause the real exchange rate to appreciate and hinder competitiveness. These developments manifest a major failure of Greece—and for that matter of other Eurozone countries—to exploit the post-EMU capital flows in order to upgrade and expand production.

The fiscal decline started with the disappearance of primary surpluses after 2003 and culminated with rocketing public expenditure and the collapse of revenues in 2009. Revenues declined as a result of a major cut in corporate tax rate from 35% to 25% in 2005 and inattention to the collection of revenues.

It was becoming evident that stabilizing the economy was not a policy priority. Concerned over the rising deficits in 2007, the government sought a fresh mandate to redress public finances, but—despite securing a clear victory—no such action was taken. Only a few months before the global crisis erupted, the government claimed that the Greek economy was 'sufficiently fortressed' and would stay immune to international shocks. Even after 2008, the government hesitated to implement measures to stem fiscal deterioration or to expand public spending to fight off the prospect of recession. A compromise included a consumption stimulus at the end of the year, combined with a bank rescue plan of €5 billion and a pledge to raise extra revenues. The first two were quickly implemented, whilst the latter was forgotten.

Weakened by internal divisions, the government opted for a general election in October 2009 as a new opportunity to address the mounting economic problems. The fiscal consequences were stunning: total public expenditure was pumped up by more than 5 percentage points, exceeding 31% of GDP at the end of 2009. (In actual amount, it exceeded €62 billion, twice the size in 2003.) The rise was entirely owing to consumption, as public investment remained the same at 4·1% of GDP.

Total receipts in 2009 fell by another 4% of GDP as a result of widespread neglect in tax collection and emergency capitalization of Greek banks. The deficit was revised from an estimated 6·7% of GDP before the elections to 12·4% in October 2009, and finally widened to 15·4% of GDP by the end of the year.

Even then, the budget for 2010 included an expansion of public expenditure while excluding privatizations, rather than the other way around. Rating agencies downgraded the economy, sparking massive credit default swaps in international markets.

But instead of borrowing cheaply in the short term as a means of gaining time to redress the fiscal situation, the government continued to issue long maturities, despite the escalation of costs. This had dramatic consequences in the international markets where a Greek liquidity problem, having the cash to meet the next interest payments, became a solvency problem, a fear that Greece would never be able to repay its existing debt.

The borrowing capacity was further undermined when the ECB threatened to refuse collateral status for downgraded Greek bonds, fuelling fears that domestic liquidity would shrink and precipitating a capital flight from Greek banks. In early 2010, borrowing costs started to increase for both short- and long-term maturities, Greece had become a front page story worldwide and the countdown began. In April 2010 the government was financially exhausted and sought a bailout.

The global financial crisis in 2008 revealed that countries with sizeable current account deficits are vulnerable to international market pressures because they risk a 'sudden stoppage' of liquidity. As Krugman (2011) recently suggested, the crisis in the southern Eurozone countries had rather little to do with fiscal imbalances and rather more to do with the sudden shortage of capital inflows required to finance external deficits.

This explains why, immediately after the crisis, sovereign spreads peaked, mainly in economies with large external imbalances, such as Ireland, Spain, Portugal and the Baltic countries, which were under little or no pressure from fiscal deficits. It is worth noting that countries with substantially higher debt burdens, such as Belgium and Italy, experienced only a small increase in their borrowing costs at that time.

Since Greece had a dismal record on both deficits, its exposure to the credit stoppage soon became a debt crisis. The current account was in free-fall after 2006, when domestic credit expansion accelerated, disposable incomes were enhanced by tax cuts and capital inflows from the shipping sector peaked as a result of the global glut. The external deficit exceeded 14% of GDP in 2007 and 2008 but no warning was raised by any authority, domestic or European. In fact, the government acted pro-cyclically and decided to reduce surcharges on imported luxury vehicles, responding to the pleas of car dealers. This opened the way for the pre-electoral spree.

Two facts emerge. One is that in periods of recession counter-cyclical activism usually takes the form of increased consumption, not public investment, and this has detrimental effects on public and external deficits without contributing to higher growth. Another recurring characteristic is the propensity of governments to increase public spending and to tolerate lower revenues in elections years.

EU authorities were unprepared for the Greek problem and undertook action only when they recognized the risks it posed for the banking systems of other European states. A joint loan of €110 billion was finally agreed in May 2010 by the EU and the IMF to substitute for inaccessible market borrowing. The condition was that Greece was to follow a Memorandum of fiscal adjustments to stabilize the deficit and structural reforms to restore competitiveness and growth. In the event of success, Greece would be ready to tap markets in 2012 and then follow a path of lowering deficits and higher growth.

Faced with a deepening recession and a failure to produce fiscal surpluses sufficient to guarantee the sustainability of Greek debt, the European Union intervened twice to revise the terms of the Memorandum. In the first major intervention in July 2011, the amount of aid was increased by €130 billion and repayment extended over a longer period.

Crucially, the EU recognized the perils of recession and allowed Greece to withdraw a total amount of €17 billion from structural funds without applying the fiscal brake of national co-financing. The plan looked powerful, except for the typical implementation lags. The agreement was only voted through by all member-state parliaments in late September 2011 and the release of structural funds was approved by the European Parliament in late November. Participation in the Private Sector Involvement had reached only 70% of institutional holders amid speculation that post-agreement buyers of Greek debt from the heavily discounted secondary market were expecting a huge profit.

Thus, a new intervention looked inevitable and in October 2011 a revised restructuring was authorized, envisaging cuts of 50% of nominal bond value that would eventually reduce Greek debt by €100 billion. Greek debt was expected to be stabilized at 120% of GDP by year 2020. The agreement was hailed in Greece but euphoria turned sour when the government surprised everybody by seeking a referendum for its approval. In the ensuing furore, the decision was annulled, the prime minister resigned and a coalition was formed in November 2011 to implement debt restructuring and to negotiate terms for the new round of EU-IMF loans.

Routinely considered the habitual wrongdoer, especially when compared with the other countries (Ireland and Portugal) which are undergoing similar adjustment programmes, a Greek exit from the Eurozone started to attract attention both at home and abroad.

Although the complications and costs in the banking sector would be enormous, the exit of Greece could prove attractive to some European politicians who get angrier every time a new round of aid is discussed. However, they overlook the fact that a Greek exit would lead to an aggravation of the crisis. If the result was a two-tier model of Economic Governance, based on an inner core of surplus economies in the north and a weaker periphery in the south, competitiveness can only be restored by a so-called 'internal devaluation' of labour costs, thus perpetuating the gap that is already widening between the Eurozone countries.

For Greece, exit would trigger an economic catastrophe. As the entire Greek debt would remain in euros, the rapid depreciation of the new national currency will make its servicing unbearable and the next move will be a disorderly default. Isolation from international markets would drive away investors while the financial panic would drain domestic liquidity on a massive scale. The creditor countries of the EU would start demanding repayment of their aid loans, and this would soon deprive Greece of its claim on the EU cohesion funds. Tensions would produce further conflicts with EU agencies and the pressure to consider complete disengagement from the European Union would gain momentum.

The only option for Greece is to complete the fiscal adjustment and become reintegrated into the Eurozone as a normal partner. To gain credibility, Greece must achieve key fiscal targets quickly in order to be able to revise some of the pressing—although so far unattainable—schedules and ensure greater social approval. To ensure that there will be no spending spree in future elections, the best option for Greece is to adopt a constitutional amendment on debt and deficit ceilings, just as Spain did in September 2011, alleviating market pressures, at least for the time being.

Greece needs a fast-track policy for exiting the long recession. €17 billion could be routed immediately to support major infrastructural projects and private investment in export-oriented companies. The growth-bazooka should be followed by structural reforms and privatizations to attract private investment as market sentiment is restored. In addition, instilling growth will help to control the debt dynamics and reduce public deficits without ever-rising taxes.

The Greek economy has cumulatively shrunk by nearly 15% since 2008, social tensions are multiplying and the future of Greece in the Eurozone is in jeopardy. Some consider such an outcome as a due punishment for past excesses, while others see it as an escape from further unemployment and recession. Both are illusory. The only viable way out of the current crisis is to restore growth and to adopt a realistic plan for privatizations and reforms. The lesson of the past two years is that the deep recession will otherwise continue to hinder any exiting from the crisis. Greece, and perhaps other Eurozone countries, need a 'corridor of confidence', to use Keynes' famous phrase, in order to put things in order.

Nicos Christodoulakis is a professor at the Athens University of Economics and Business. He was the Greek Minister of the Economy and Finance between 2001 and 2004. During the Greek EU presidency in the first half of 2003 he was chair of the Euro group and the Economic and Financial Affairs Council (ECOFIN). Extracted from The New Palgrave Dictionary of Economics March 2012; Palgrave Macmillan.

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