Posted in Finance Articles, Total Reads: 865
, Published on 11 March 2015
Eurozone and Greece seem to be in a particular tussle. The election of Alexis Tsipras as the new Prime Minister gives a new turn to the ongoing story. He seems to be in a mood to put an end to the tough austerity measures that Greece has had to face in the recent past. He also has plans to break free from the bailout programs. With cash-strapped Greece in a real dire position, what remains to be seen is whether Greece’s debt write-off will be accepted by its debtors or will Greece finally have to breakout from the Eurozone as is being predicted by the likes of Alan Greenspan (former Chairman of the US Federal Reserve). To understand what options Greece has, it is indeed worthwhile to understand what actually led to this conundrum.
Greek Debt Recession and Austerity
Greece’s Public Debt had been growing at a dramatic level (Figure.1). Also Greece had huge amount of debt, but the GDP i.e. the productivity of Greece was and is still not high enough . Thus this is a problem. What matters is how much a country owes relative to how much it can actually produce. So Greece’s Debt as a % of GDP increased and is currently well over 100%.
A major reason for the debt-to-GDP ratio being above 100% is because the Public Revenue, the taxes that the Greek Government gets, is consistently lower than its Public Expenditures (Figure.2). This leads to deficits. Thus this deficit spending on a year on year basis increases Greek Government’s debt. The rising debt increases people’s suspicions and thus interest rates increase owing to the increased riskiness. This brings on more burden upon the government which is already under the debt burden as highlighted above.
Figure.1 Public Debt Vs. Debt-to-GDP Ratio
Figure.2 Public Revenue Vs. Public Expenditure
A simple solution (Solution No.1) to the debt problem may seem to be increasing taxes and decreasing spending. But this is easier said than done. The Greek Government had already made huge promises to people in the form of Government obligations i.e. pensions, entitlements etc. If the Government went back on its promises, there would be lots of people e.g. retirees who are dependent on these obligations and they would not be too pleased with Government. It is also politically not the best thing to be done.
Greece is already in a fairly severe recession (Figure.3). Although the forecasted GDP growth numbers may provide some respite, however the debt burden does not seem to decrease in the coming years. Thus increasing taxes and decreasing spending would suck air out of the economy. Austerity (efforts taken by government to reduce expenditures to shrink growing budget deficits) leads to further slowing of Greece’s economy. As deficit’s worsen, interest rates go up, taxes go down which implies that revenues go down further. This would lead to GDP dipping further which would only lead to increasing Debt-to-GDP ratio. Thus although the EU (European Union) helped Greece in this tough time, with Germany in the forefront, it laid these conditions of austerity which only led to further weakening of Greece’s economy.
Figure.3 Public Debt Vs. Real GDP Growth Rate
(Secondary axis highlights Real GDP Growth rate)
Greek Financial Crisis
Although the deficits were piling up year after year, a major fault of the Greece Government was that it tried to cover up this for years together with some accounting shenanigans. This was because there were some ECB (European Central Bank) rules on the amount of debt which a country could take on. Greece wanted not to trigger those rules while still being able to take on more debt to fund its spending program. But once the shenanigans were cleared it led to revelation of a larger than perceived Public Debt. Thus the combination of non-transparent obligations and the huge debt burden made people wary of whether Greece would be able to fulfil its debt obligations. Investors’ (people who held Greek Bonds) trust went for toss and they expected higher interest from the Greek Government. Thus, Greek Governments’ debt burden increased.
A simple and logical solution (Solution No.2) to the above problem seems to be that Greece simply default on its debt. However a chain of events would occur if this were to happen. In the event that Greece defaults on its debt, all those who would have lent to Greece would no longer lend to it. Thus no more Euros for Greece to spend on its obligations and promises of pensions, to retirees etc. This would be a case of fast and violent austerity which has the potential to lead to a drastic shut down of the Greek Government.
How and Why Greece would leave the Eurozone
Speculation has been rife that Greece would leave the Eurozone in the near future. This in economic terms would be a major blow to people of Greece as well as Greece’s debtors.
Greece exit from Eurozone can also be counted as an option (Solution No.3) available to Greece. However, an exit from Eurozone would have serious repercussions for Greece as well as for Eurozone in particular.
Let us assume hypothetically that Greece would leave Eurozone. This would mean that Greece would no longer come under the ambit of ECB. Thus it would have a currency of its own. Let’s say the currency is Drachma (Greek currency before it became a part of Eurozone). Thus the Greek Government would now have the liberty to simply print more money and inflate away its obligations of pensions, retirees etc. A huge amount of money would mean higher inflation. But considering the fact that the Greek Government does want a respectable amount of inflation since there is already empty production capacity to capitalize on and Greece is already in a very slow GDP growth mode this would not be a bad idea. However, this solution will undermine investor trust going forward.
All the Euro currencies in the banks would now be converted into Drachma depending on the exchange rate set initially by the government. However, going forward, this exchange rate would be determined by exchange markets. Thus all buying and selling would now occur in Drachma. This implies a debt default because it would mean telling the debtors that Greece no longer owes them say 500 Billion Euros, but 300 Billion Drachmas (considering that the exchange rate is 0.6 Drachma/Euro). Even if it were 1 trillion Drachma, it would still be counted as a default as it would mean repaying them (debtors) with something other than what they were expecting (amount in Euros).
Public sentiment would also play a major role. If Greek Government announces that all the Euro currency in the banks would now be converted to Drachma (1:1), people know better that when these currencies trade on exchange markets, part of their money would get wiped out because a Drachma would not be equivalent of a Euro. Thus they would start withdrawing their Euros from banks. Since there is a fractional reserve banking system, if this withdrawal happens on a large scale, which is quite probable, it may lead to bank runs and subsequently massive bank failures. Potentially, the whole Greek Banking System could suffer a systemic collapse. There would also be no one to help considering that Greece as of now does not have a central bank of its own.
Why Europe is Worried About Greece
Possible Political Ramifications
When an economy falls apart there is huge amount of unemployment which can lead to social unrest. There even may be radicalization of views which is a very scary proposition. History of Europe tells us that even if a relatively small countries in Europe fall apart in this way, it could have repercussions in the rest of Europe. This is how World War I and World War II got started. This reason alone is enough for people to think very seriously about bailing Greece out.
Unemployment was already high and has been going through the roof with the current rate standing at 25.4 % considering all the age groups. For people with age group less than 25 years, the unemployment rate stands at an astounding 49.3% (Figure.4). Also the long term interest rates are already higher than most other countries (Figure.5)
A Greece exit from Eurozone would spark a chain reaction meaning that economies like Italy, Portugal , Ireland would also slow down as investor confidence would deteriorate and they would demand more interest from these countries also. Thus there is a fear that they would go in the same direction as Greece thereby making Greece a point of instability in Europe.
Figure.4 Unemployment Rate
Figure.5 Long Term Interest Rates
This article has been authored by Avinash Mehta from IMT Ghaziabad