Greek Financial Crisis: Origins, Responses, and Lessons

The global financial crisis in 2008 has striked hard the Greek economy with high
public debt refinancing and its accumulation since 1980s. Greece later became the center of
attention in Eurozone particularly after the elections of October 2009 when newly chosen
government exposed that the previous government had been falsifying the budget data. The
budget deficit for 2009 was estimated as 12.7% of GDP whereas the previous government
presumed that the deficit would not be higher than 6.5%. This unexpected higher deficit level
led to upsurge in bond spreads to unsustainable level, threating to destabilize the euro area.
Therefore, this essay will thoroughly discuss the origins of Greek financial crisis, about what
factors have contributed, related policy responses, and some lessons drawn from the crisis.
According to Kouretas (2010), endogenous and exogenous factors have contributed to
the Greek financial crisis since its first explosion on October 2009. Endogenous factors were
related to the structure of the Greek economy, the historical macroeconomic imbalances, and
the credibility of macroeconomic policy. Meanwhile, exogenous factors were associated with
the consequences of current financial shock and the response of Europe to the Greek financial
crisis. Before we begin our discussion of both factors, it is necessary to take a look at the
issue of public debt sustainability as the heart of sovereign debt crisis.
Fiscal sustainability implies that the government should keep the present value of
primary surpluses to be equal or greater than original debt as described by intertemporal
government budget constraint below;

(1)
where E refers to expectations, B is public debt, r is real interest rate, and S is primary surplus
of government budget. Meanwhile, the equation (1) can be simply written in the flow version
as follows:
(2)
The equation (2) points out that the government deficit in the left hand side comprises of
interest payments on the debt minus the primary government surplus in the right side. Hence
in this case, the government deficit reflects to an increase in government debt. In terms of
GDP, we have;
(3)

where b is ratio of debt to GDP, s the ratio of primary surplus to GDP, and g the growth rate
of GDP. The primary surplus to GDP ratio in equation (3) is related to fiscal sustainability.
When it is lower, the fiscal situation becomes unsustainable and the government will be
insolvent. Therefore, based on the equation (3), there are four factors determining fiscal
sustainability: ratio of predetermined debt to GDP, share of primary surplus to GDP, the real
interest rate on government bonds, and the real GDP growth rate. All these factors other than
primary surplus are outside the government control.
The GDP growth rate depends on the domestic investment, the expectations about the
profitability of investment, domestic savings, and the real interest rate in the short run and
medium run. Meanwhile in the long run, growth rate is determined by population growth and
technological progress, which is exogenous. The real interest rate is also exogenous and
outside the government control especially for a small open economy with full capital mobility
like Greece in monetary union. The historical sovereign debt to GDP also can not be changed
and the ratio of debt to GDP is determined through accumulation process of the previous
government budget. However, the government still be able to control the primary surplus to
GDP ratio directly to attain solvency in the short run by expenditure and tax policy. Hence, to
help explaining the origins of the Greek crisis, the next section will discuss the historical
sovereign debt of Greece prior to crisis.
It is not arguably that widening public deficit as endogenous factor played an
important role on the fiscal deterioration in Greece. In 1970s, Greek government only
allowed deficits in the public investment program. However, since 1978 the government
started to abandon this regulation and public debt became exploding during 1981. According
to Alogoskoufis (2012), there are three main reasons for this upsurge of public debt to GDP
ratio: high primary government deficits, slowdown in economic growth, and government
guarantee.
The first reason was triggered by the socialist electoral who undertook expansionary
fiscal policy funded by internal and external debt and inflows from European Community.
Until 1990, the government deficit achieved 10% of GDP on average. This high primary
deficit, along with interest payment take over, have contributed as the source of fiscal
destabilization. Due to financial liberalization in the second part of 1980s, a rise in interest
rate also had additional effect on deficit eventhough its financing got easier since the Greek
bonds became more attractive. The next reason, slowdown in economic growth during the
1980s has adversely affected the denominator of the ratio and dynamic movement of the debt.
Meanwhile for the third reason, government guarantees for loans of private and public

enterprises led to public debt increase since half of them were taken up by government in
1992.
And the main incident which plunged Greece into sovereign debt crisis took place, the
international financial crisis of 2008. This crisis has exacerbated the public finances through
bail out in which the government took over major share of the debts of problematic financial
institution, and expansionary fiscal policy like stimulus program which aims to increase
aggregate demand and to avoid deep recession. Moreover, according to Malliaropoulos
(2010), the decline in competitiveness since joining EMU caused to persistent deficit in the
current account. These twin deficits make the reputation of Greek government to repay its
debt in doubt so that investors are demanding higher interest rate to lend money to Greece.
This in turn will lead the Greece government to issue new bonds with short maturity and
higher interest rate, as reflected in widening Greek spreads to Germany as an anchor in
Eurozone. As a result, the main rating agencies decided to downgrade the credit rating of
Greek Bonds into BBB-.
Meanwhile, from exogenous perspectives Eurozone was not successful to give signal
about their willingness to support Greece from financial crisis. An issue about the legality of
bailouts was raised by Germany eventhough Masstricht treaty did not mention anything that
prevents a Member State of EU to help a country in financial difficulty. Another exogenous
factor that is related to instability of Greek economy was lack of solidarity funds in Eurozone.
Since it is a monetary union not an economic union, economic policy other than monetary
policy like budgetary policy is still in the responsibility of national decision makers. Hence,
how did the Greek government respond while dealing with crisis?
In March 2010, the Greek government announced tax rises and spending cuts totaling
$6.5 billion. In May 2010, with fears of default on Greek debt the government really need
money quickly and then accepting the three-year rescue package of 110 billion by dealing
with more strict and austere measures, such as further tax rises on fuel, alcohol, and tobacco
by 10% and more cuts in pensions and public sevice to achieve the targeted public deficit by
3% of GDP in 2014. Eventhough this bailout required Greece to cut its budget, this rescue
program did not stimulate the economy as suggested.
The stimulus package increased the Greek debts without facilitation for the Greek to
repay the debt. This only caused to further economic slowdown in which the enterprises fired
their workers more often, driving up the unemployment rate with lower business and
consumer spending. In order to maintain the economy, Greece was forced to borrow more
money which in turn would lead to debt increases. As a consequence, Greece plunged into

deeper recession with economic shrinkage by almost 12 percent between 2009 and 2011.
According to Podaras (2012), more than half amount of loan to Greece in 2010 bailout even
went to repay bondholders. Such a wasted transfer of billion euros from taxpayers around the
world to the investment in the troubled nation!
After evaluating the first bailout in 2010 about why it did not have any impact as it
should be, we can take a look at how the second bailout proceed. Since the crisis worsened in
July 2011, European Union agreed to bailout Greece by channeling 109 billion through
European Financial Stability Facility. Then, all the credit rating agencies downgraded Greek
rating into substantial risk of default due to Greeces ability to repay its debts. In October
2011, Eurozone agreed to write-off 50% of Greece debt in exchange for further austerity
measures.
In March 2012, Eurozone finally approved second bailout by 130 billion with
conditional debts slashed for Greece as worth as more than 100 billion by swapping its
bonds for longer maturity bonds with less than half the nominal value. With this bond swap, it
was expected for Greeces debt to fall from 160%, reaching 117% of GDP in 2020. The
advantages of this package was the assurance of repayment and the positive impact for
banking sector (Papadimitriaou, 2011). However, some predicted that a recession would be
much worse with higher unemployment rate and lower inflation rate due to demand weakens.
Again, this bailout option was still better than leaving eurozone. Leaving eurozone will
worsen the debt since there is no support of EU and Greece will be pushed to borrow at very
high interest rates. The debt became more unsustainable and more difficult to repay and even
led to huge inflation.
From the Greek crisis and its policy response described above, we learned that the
cost of recovery after financial crisis is extremely high eventhough the stimulus plan did not
restore growth and even brought Greece into economic slowdown with higher unemployment
rate. Hence, according to Provopoulus (2010) in his speech on the Financial and Economic
Crisis, we can draw four lessons from the crisis with empashizing on fiscal policy. First, the
systematic implementation of fiscal policy in the past can bring on debt-sustainability
problem, limiting the current implementation of fiscal policy. Hence, distinctive actions are
needed to attain credible fiscal consolidation. Second, instead of smoothing adjustment to
shocks Greece fiscal policy became the major origin of shocks which led to an increase in
bureaucratic inefficiency. Third, fiscal transfers while dealing with permanent shocks can
prevent essential adjustment. Structural reform needs to be introduced to improve the
competitiveness by allowing transfer of resources to the more dynamic sector. And last, a

country with huge fiscal imbalances in a monetary union can cause negative spillover effect
by increasing the cost of debt servicing and raising interest rate for other members in the
union. Hence, monetary policy needs to be harmonized with fiscal policy to maintain interest
rate in order to accelerate growth and employment in the entire euro area.
In conclusion, we know that the origins of Greek financial crisis come from two
factors: endogenous and exogenous. Endogenous factors were related to the structure of
Greek economy, such as the widening of public deficit and persistent deficit in the current
account. Both deficits influenced the reputation of Greek government to repay its debt so that
investors are demanding higher interest rate to lend money to Greece, as reflected in
widening Greek spreads to Germany. Meanwhile, exogenous factors were associated with
responses from Eurozone to help Greece from financial crisis. In this case, Eurozone could
not give clear signal due to the bailout issue and lack of solidarity funds. As a response
toward the crisis, the government announced to raise tax and cut the budget in order to accept
the rescue package. However, this rescue program did not stimulate the economy. But this
bailout option is believed to be better than another option like leaving Eurozone since that
would be more difficult for Greece to repay the debt with extremely high interest rate. From
this crisis, we may learn that fiscal policy at the past can limit the role of current fiscal policy,
and monetary policy in monetary union needs to be harmonized with internal fiscal policy to
avoid the negative spillover effect from a country with huge fiscal imbalances.
REFERENCES
Alogoskoufis, G. 2012. "Greeces sovereign debt crisis: retrospect and prospect," LSE
Research Online Documents on Economics 42848, London School of Economics and
Political Science, LSE Library.
Kouretas, G.P and Vlamis, Prodromos. 2010. The Greek Crisis: Causes and Implications.
Panoeconomicus, 4: 391-404.
Malliaropoulos, D. 2010. How much did Competitiveness of the Greek Economy Decline
since EMU Entry? Eurobank Research, Economy and Markets, 5(4): 1-16.
Papadimitriaou, D. The Debt Crisis in Greece. CBS: Student Theses.
Podaras, A. 2012. "The Greek Financial Crisis: An Overview of the Crisis in Entirety and
Proposed Measures: Recommended Solutions and Results." Honors College Theses. Paper
109.
Provopoulus, G.A. 2010. The Greek economic crisis and the euro. BIS Review 87/2010.