The Economics of Austerity and the Vicious Spirals of Greece

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The Economics of Austerity and the Vicious Spirals of Greece

Nikolai Vike

Master´s thesis for the degree

Master of Economic Theory and Econometrics Department of Economics

UNIVERSITY OF OSLO

May 2016

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The Economics of Austerity and the Vicious

Spirals of Greece

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The Economics of Austerity and the Vicious Spirals of Greece Nikolai Vike

http://www.duo.uio.no/

Trykk: Reprosentralen, Universitetet i Oslo

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Summary

After Greece joined the European Monetary Union in 2001 the country accumulated many macroeconomic and financial vulnerabilities. Easy access to international funds at low borrowing costs in combination with high economic growth reduced the real value of debt and stimulated to increased borrowing by governments in several euro-countries in order to finance fiscal deficits which further worsened their current-account deficits, especially in Greece and Portugal. Greece’s large and negative current-account balance made the country especially prone to a financial crisis as the country relied heavily on foreign capital inflows. After the financial crisis in 2008, capital inflows into Greece froze and the country had to reduce its deficits. In 2009, new revisions about earlier reported macroeconomic numbers where revealed and they turned out to be much worse than earlier reported. Fis- cal mismanagement and deception through misreported statistics throughout the period from 2001 when Greece joined the euro harmed investor confidence when the true numbers were revealed, hence increasing borrowing costs and raised the spreads on sovereign bonds. The sharp decline in capital inflows from surplus countries in combination with soaring interest rates on sovereign debt made it impossible for Greece to re-pay its debt.

Since then, Greece has received three bailout packages from the IMF and the European community. The loans where disbursed in smaller amounts conditional on whether Greece managed to satisfy several conditionality criteria which were included in the deal. Greece had to reach strict fiscal targets underway which forced the country to implement a mix of structural reforms and fiscal austerity. The goal of this thesis is to analyse and discuss the effectiveness and risks associated with such policy in crisis-stricken Greece, using two different macroeconomic models.

Based on the standard definition of sustainable debt by the IMF, chapter two shows in this model with a risk premium extension by Mehlum (2012) that, by increasing the primary surplus through austerity in order to achieve a sustainable debt level, interest rates on bonds will increase as a response to the austerity and the uncertainty that such measures represent. By extending the model to include a negative relationship between austerity and economic growth, the model contains an unstable equilibrium at a lower level of the debt stabilizing primary surplus than otherwise. The model can be used to show that a significant debt relief could eliminate the unstable equilibria and the threat of

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a vicious spiral in the market for sovereign debt. However, in the extended version of the model this is not the case. With a negative relationship between austerity and growth, an unstable equilibrium still exists even after the debt relief. Thus, any significant adverse economic shock to any of the variables in the model could force Greece back into difficul- ties. The model implies that, in order to avoid a vicious spiral in the market for sovereign debt, Greece needs a debt restructuring in order to stay away from the crisis zone where risk premiums and growth reductions are continuous threats. In order to remain in the good and stable equilibrium, Greece needs economic growth. The model shows how the ECB instrument of outright monetary transactions could eliminate the bad equilibrium by promising to intervene in the market for sovereign debt and secure a maximum price on bonds. The very existence of the instrument could eliminate the fear of a vicious spiral and the promise of intervention could be enough. However, the extended version of the model shows that, as long as there is a negative relationship between the debt stabilizing primary surplus and growth, the promise of intervention is no longer enough and the ECB could be forced to intervene.

According to Gali et al. (2007), Christiano et al. (2011), DeLong and Summers (2012), Auerbach and Gorodnichenko (2012) among many others, there is much to gain from fiscal stimulus during a recession as the fiscal multiplier exceeds unity. Based on a Keynesian model as shown in Holden (2015), chapter three shows how the extraordinary circumstances of the Greek crisis might result in a distress premium which somewhat offsets the positive effects from debt-financed fiscal stimulus. The interlinked crises of sovereign debt, growth and banking, in combination with the insecurity and distress associated with a possible Grexit, could give rise to so much distress that any debt-financed fiscal stimulus could loose its effect through increased distress premiums. Normally, as shown by DeLong and Summers (2012), fiscal stimulus during a recession will increase expected inflation and reduce the risk spreads - further reducing the real interest rate.

However, the IS-DP-model could imply the opposite. Next, by using a model by Mehlum (2014), chapter three further discusses how austerity during a recession could result in a total collapse of the economy as a result of continuously increased recession premiums.

Fiscal austerity could also reduce the beneficial effects from the ECB instruments of tar- geted longer-term refinancing operations and the corporate sector purchase programme.

The ECB is increasing supply of credit in an environment where fiscal austerity depresses demand. Fiscal austerity also brings with it severe political and social effects. As argued by Sinn (2014), even though fiscal austerity could improve Greek competitiveness if also surplus countries are willing to simultaneously reduce their advantage in trade, differential inflation could lead to a rebalanced eurozone. But this is difficult to achieve in a monetary union with a central bank that follows a mandate of achieving price stability. This thesis suggests that fiscal austerity during a recession implies several risks and should be delayed

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until Greece is no longer threatened by all the possible adverse effects discussed throughout. The Greek crisis contains so many interlinked vulnerabilities that a solution calls for bold and coordinated measures beyond austerity. Any beneficial effects that austerity might imply could in all likelihood not be achievable in a distressful economy threatened by vicious spirals and social strife.

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Preface

Even though writing this thesis has been a demanding challenge, it has most of all been an enjoyable and inspiring time. The process brought me from writing my basic bullet- points at Blindern in early January to proudly making my final notes while sitting in an Athenian garden-caf´e with a good view over the Acropolis in late April. When I found myself among the monuments of the Acropolis or in front of the Greek Parliament it really hit me how ironic it is that Greece - the birthplace of democracy - is now the European center stage of economic and political drama. First of all I would like to thank my supervisor, Professor Halvor Mehlum, for helping me formulate a research question which perfectly fitted my interests and ideas, and for his excellent guidance throughout the semester. I would like to thank my brother, Magnus Ripegutu Vike, for sharing his linguistic expertise. I would also like to thank my fellow students and good friends, Snorre Solli, Kjetil Tveit Moen, and Suzanna Rye for commenting on earlier drafts of the thesis and for kind and motivating words throughout the process.

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List of Figures

2.1 Source: Eurostat. Average general government budget balance between 2003-2007 as percent of GDP . . . 8 2.2 Source: Eurostat. Current Accounts in the Eurozone in 2007 as percent of

GDP . . . 9 2.3 Source: Macrobond. Quarterly evolution of Greek public debt . . . 12 2.4 Source: Macrobond. Greek unemployment rate . . . 13 2.5 Source: Macrobond. 10-year yields on government bonds among four eu-

ropean countries . . . 15 2.6 Source: Eurostat. Evolution of Greek gross government debt as percent of

GDP . . . 21 2.7 The possibilities of a vicious spiral and the effects of a debt relief in the

case of (i) fixed rate of interest (ii) risk premium . . . 26 2.8 Alternative (iii): The vicious spiral between investor confidence, growth,

and sustainability and the effects of a debt relief . . . 28 2.9 The effects of Outright Monetary Transactions . . . 29 3.1 Typical (Y, i)-diagram with a fixed exchange rate . . . 33 3.2 IS-DP: The effect of a positive shock to government expenses with distress

premium in a monetary union . . . 40 3.3 Source: European Commission AMECO database. The evolution of in-

direct taxes, direct taxes and social contributions in Greece as percent of GDP. . . 42 3.4 Source: European Commission AMECO database. The evolution of Greek

total general government expenditures as percent of GDP between 2008-2016. 43 3.5 Source: European Commission AMECO database. The convergence be-

tween Greek total expenses and revenues as percent of GDP between 2008 - 2016. . . 44 3.6 IS-RP: The effect of a negative shock to government expenses with an

endogenous recession premium in a monetary union . . . 47

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List of Tables

2.1 Source: The Bank of Greece, Eurostat, and AMECO. Economic Statistic Table for Greece between 2007-2016 . . . 16

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Chapter 1 Introduction

The Greek debt crisis led the country into a recession in late 2009 with a debt-to-GDP ratio at an unsustainable level. As a member country of the European Monetary Union (EMU) Greece could not use monetary policy as a stabilizing tool and was therefore left with internal devaluation after the financial crisis hit Europe. The resulting sharp decline in wages and GDP growth made it even more difficult for Greece to honour its debt.

Greece was therefore forced to negotiate an adjustment programme in 2010 in order to receive a bailout package from other European governments and the IMF (International Monetary Fund). But Greece fell into deeper recession and the first bailout package would later be followed by two more. The programmes included several conditionality criteria of structural reforms where fiscal austerity was inevitable. Those programmes were supposed to improve the unsustainable debt level, reduce the primary deficits, safeguard financial stability and modernize the State. While the programme did result in lower primary deficits, it also led to social and political turmoil and further macroeconomic instability.

From 2009 and up until the end of 2015, primary deficits have been reduced from 10 to 3 percent of GDP. However, during the same period unemployment rose from 12.7 percent to 25.1 percent and wages were cut. In addition, bond yields soared while the debt-to- GDP ratio continued to increase and real GDP growth continued to decline, as if there was a vicious spiral. Every country that spend beyond their means will eventually face a period of cuts. But as the Greek debt crisis has shown - austerity pushed too far may create significantly adverse effects and disturbances during the period of adjustment.

According to the classical Keynesian theory, cuts or increases in taxes and government expenses are driven by a multiplier which further magnifies the original action.

Thus, countries facing a downturn should use expansionary fiscal policy, and use con- tractionary fiscal policy only to cool down an overheated economy. However, in order to minimize the amount of financial aid, Greece’s creditors such as the IMF and the Euro- pean Financial Stability Facility (which later evolved into the current European Stability Mechanism (ESM)) required the Greek government to agree on fiscal consolidation in

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order to get the debt level and primary deficits under control as fast as possible. Strict fiscal discipline might not only mean minimized costs for the creditors, but it could also create expansionary effects in the Greek real economy. This policy proved to be costly for all parts as the austerity brought with it severe adverse economic, political and social effects. From a Keynesian point of view, some of the actions taken have been contradic- tory and inefficient - pushing Greece closer to a bad equilibrium than towards prosperity.

The economics of austerity seems to trigger a polarized debate among economists. Some argue that a combination of structural reforms and fiscal consolidation is the cure that will save a country from further misery. Structural reforms may create a more produc- tive economic base, while austerity measures provide a signal of a commitment to restore fiscal discipline, hence lay the foundations for optimistic expectations and expansionary effects (Fels and Froehlich, 1986; Hellewig and Neumann, 1987). More importantly, since the European debt crisis was a result of significant imbalances in current accounts and competitiveness, internal devaluation and austerity are required in order to truly fix the underlying problems that lead to a crisis in the first place (Sinn, 2014). However, others argue that the difference between reforming a bad administrative structure and economic austerity has been lost in crude financial thinking and suggest that the way of practising fiscal policy should return to the Keynesian way of thinking about economics, where austerity should be used as a mechanism to cool down an overheated economy, and should not be analysed without considering the adverse political and social costs that are doomed to follow if used during a recession (Stiglitz, 2002; Krugmann, 2013; Wolf, 2014; Sen, 2012, among others). The goal of this thesis is to discuss these opposing views and cast more light on the relative costs and benefits associated with each. Was the Greek crisis a result of excessive spending over income? Did the austerity measures prove to be successful in restoring growth and improving the underlying conditions which lead to a crisis in the first place? How does fiscal austerity affect public finances? How does a fiscal expansion affect the Greek real economy in a recession? How does fiscal austerity affect the Greek real economy in a recession? These questions will be discussed in this thesis.

The thesis is structured as follows: chapter 2 gives a short overview of the Greek debt crisis and discusses key macroeconomic variables of Greece and how they developed during the last decade. The next section takes a closer look on the algebra of sustainable sovereign debt and the theories of strategic debt accumulation and self-fulfilling debt equilibria. Then I analyse the evolution of public debt by applying a model which captures the links between debt, interest rates, growth, and investor confidence and discuss the factors which might trap the debt level in a bad equilibrium. The analysis builds on a model by Mehlum (2012) and is extended by modelling the link between austerity and economic growth. Chapter 3 starts by briefly discussing the Keynesian model as described by Holden (2015) and the fiscal multiplier before further discussing the the factors which

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could make the multiplier large or small in times of crisis. Next, I introduce a variable of distress and analyse why expansionary fiscal policy in Greece might work insufficiently when the fiscal stimulus is financed by foreign loans which only increases the debt level and adversely affects a banking sector in distress. This variable might also be a function of several other extraordinary circumstances of the Greek economy, making a positive fiscal multiplier somewhat offset by the negative effects from continuously increased distress premiums. The next section gives a short overview of the austerity measures and prior actions Greece has implemented in order to receive bailout packages from the IMF and the ESM. Then the Keynesian model is further extended to include an endogenous recession premium as suggested by Mehlum (2014) in order to model an environment where fiscal austerity during a recession creates a vicious spiral in the real economy. The chapter further discusses the theory of expansionary fiscal contractions and other theories which provides some arguments in support of austerity during a downturn. Finally, the chapter discusses some political and social adverse effects of austerity. Chapter 4 concludes and will shed more light on the polarized debate which characterizes the economics of austerity.

Keywords: Fiscal austerity, recession, current account, sovereign debt, risk premium, economic growth, vicious spiral, debt-to-GDP ratio, government expenses.

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Chapter 2 The Greek Crisis and Recovery:

Fiscal Corrections with Adverse

Effects in the Market for Sovereign Debt

2.1 Fiscal Aspects of Monetary Integration: Why the Experiment Should Work

The Maastricht Treaty of 1992 sets the ground rules for the European Monetary Union.

Some of the criteria of sound fiscal policy that must be satisfied in order to join the union are that each member country’s annual government deficit must not exceed 3 percent of GDP, and that the debt-to-GDP ratio is not exceeding 60 percent, as later defined in the Stability and Growth Pact of 1997. Member countries that achieve those goals over the medium term will make it possible for the automatic stabilizers to play freely¹. This is the

”preventive arm” of the pact. The Stability and Growth Pact also contains a ”dissuasive arm” through the ”Excessive Deficit Procedure” (EDP) which ensures a correction process in every country that fails to satisfy the conditions. The dissuasive arm further contains a set of sanctions that will be imposed on any member state that fails to implement the EDP in due time. Dornbusch (1997) analyses whether so much attention to fiscal issues is at all relevant in a monetary union. By using an application of the Barro-Gordon model where the authorities minimize a loss function for a given expected rate of inflation, it serves to show how such an often used modelling framework implies how debt is a risk

1The pact allows the time horizon to vary, depending on country-specific circumstances such as the level of debt and the growth rate. Such country-specific medium-term budgetary objectives (MTOs) adds flexibility to the pact. However, one could argue that such flexibility may give rise to opportunistic interpretations, discussions and conflicts.

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factor for sound monetary policy². The higher the level of debt, the more tempting it is for the authorities to inflate away parts of it, and the higher is the optimal level of inflation. Thus, limits on debt and deficits are necessary to avoid such temptations. How- ever, Dornbusch suggests three arguments of why the focus on such limitations is overdone.

First, he argues that:

the provisions for the European Central Bank assure that the institution is independent, cannot solicit or accept guidance, and cannot finance governments. The extra provision of no bailouts of public debts eliminates an imme- diate spillover effect of poor public finance to the central bank or countries‘

budgets. Thus, insistence on debt provisions is overkill, and the dash for fiscal probity that is under way is not justifiable by a concern for sound money.

(Dornbusch, 1997, p. 222)

The no-bailout clause in the original Maastricht treaty implied that any national government that failed to meet its debt obligations had to declare sovereign default. This clause should have had the desired effect that the euro countries should not borrow excessively.

When default is the only option if a crisis occurs, countries should not have any incentives to borrow more than they can repay (no moral hazard). Second, he argues that:

the static game laid out above [the Barro-Gordon framework] seriously mis- represents the opportunities for inflationary strategies to accomplish debt reduction. In any multiperiod game there will be punishment, and that means higher nominal interest rates and worsening of trade-offs. (Dornbusch, 1997, p. 222)

As governments understand the real costs associated with this spiral, the application of the Barro-Gordon model loses some validity. Finally, he explains how a worsening of one country’s debt will not pose a threat to the overall stability of the union as bonds are substitutes. The market provides discipline as investors substitute away from holding bonds considered more risky than others. E.g. a worsening of Greek debt will be a Greek problem as investors shift from Greek bonds to, say, German bonds. Thus, there is an adjustment in all yields as the spread of Greek bonds over German bonds will rise. This adjustment implies that a debt crisis in one individual country will not spread to other euro countries. As Greece must struggle with a higher interest rate on its debt, Germany benefits from a reduced interest rate and a beneficial ”safe-haven” response. ”Hence there is one more reason why the insistence on fiscal criteria in the EMU is vastly overdone”

(Dornbusch, 1997, p. 223).

2The original model is found in Barro and Gordon (1983).

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2.2 What Went Wrong?

History shows that the no-bailout clause was not credible enough to avoid excessive debt accumulation as several countries continued to accumulate debt after joining the union.

The low credibility of the no-bailout policy made the euro-countries realize that future EMU-policies would not necessarily coincide with the once optimal plan of no bailouts - resulting in a time-consistency problem for the EMU policymakers. When the European debt crisis did happen, the no-bailout policy seemed no longer optimal as the costs associated with letting a highly indebted country default was larger than actually assisting in its recovery. Letting a highly indebted country default would imply that the creditor countries would face large economic losses. There would also be symbolic costs associated with the failure of creating a stable and strong European union. This further damaged the reputation of the no-bailout clause and provided countries with further incentives for excessive spending. In addition there already existed other international economic institutions that could provide financial assistance during times of crisis, such as the IMF with a clear mandate of achieving global macroeconomic stability. The convergence of bond yields between 2000 and 2009 reflected that investors did not expect any sovereign default to occur as the costs would be to great.

Having discussed moral hazard and the time-consistency problem, this establishes a counterargument to Dornbusch’s main message and provided a rationale for the Stability and Growth Pact. As long as there are possibilities of large fiscal imbalances among countries within the euro area, strong and well enforced common fiscal targets are needed in order to ensure the singleness of monetary policy. But even with such rules in place, a crisis did occur. This could be a consequence of the flaws within the Stability and Growth Pact itself. Some argue that there is an asymmetric incentive structure, an incentive gap, in the pact as there are sanctions for failing to meet the criteria but no rewards from achieving them (see for example van den Noord, 2007). And as argued by Sapir (2007, p. 89), national authorities may not share a sense of ownership towards the rules of the pact, and the general population may not fully understand the rationale behind it. In addition:

[...]the 3 percent rule is not based on rational economic analysis. It is an arbitrary number. Thus, intelligent people (policy makers) will not subject themselves to a rule that is perceived as unintelligent, especially when these policymakers face strong commitments vis-`a-vis their electorate during a recession. They will put the rule aside. (De Grauwe, 2007, p. 184)

Meeting the criteria was crucial for countries that wished to be a part of the EMU, but as soon as this mission was completed, incentives changed. Then, ”the only ”stick” left to the EU authorities was the less tangible risk of uncertain and delayed pecuniary sanctions

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and loss of reputation. Since SGP stipulated that fiscal positions have to be close to balance or in surplus ”over the medium run”, there was no clear timetable for compliance”

(van den Noord, 2007, p. 41). This, combined with weaknesses in enforcement, prevented the Stability and Growth Pact to work sufficiently as a preventive and dissuasive pact.

Thus, a period of fiscal convergence in the late 1990s happened as countries focused on achieving the fiscal targets in order to join the monetary union. However, this ended in a period of divergence during the 2000s as several member countries found it optimal to run large deficits and increase their public spending (more on this in section 2.4.2) rather than comply to the pact.

One of the member countries that diverged the most was Greece. Greece represents a tragic case when it comes to sound fiscal policy and it is no secret that the country has a long history of excessive spending, government budget deficits and high debt levels.

According to Dornbusch, paying much attention to fiscal issues is overdone, but this turned out to be clearly wrong in the case of Greece, especially since the no-bailout clause had little or no credibility and the dissuasive arm of the Stability and Growth Pact were insufficient to prevent deviation. In 2010, Greece received its first bailout package from the IMF in addition to bilateral loans from other euro governments. Since 2012 the situation became so severe that the prospect of leaving the eurozone emerged. But was it simply the case that the Greek tragedy, and the broader European sovereign debt crisis, was solely a problem of excessive public spending? Or was it more a problem of the broader unbalanced economic structure of the eurozone? The next section will discuss in more detail how Greece’s mismanaged economy ended in a nightmare for the EMU and themselves - a nightmare in which there is no imminent awakening.

2.3 An Overview of the Greek Debt Crisis

2.3.1 An Unbalanced Eurozone

Greece joined the euro in 2001 after a long period of adjustment away from high inflation, large government deficits and a high exchange rate relative to its trading partners. In the following years between 2003-2007, Greece and many other euro countries experienced a significant accumulation of macroeconomic and financial vulnerabilities as they fell for the temptation to take advantage of the highly liquid banking system and the economic benefits which followed after the creation of the euro. Easy access to international funds at low borrowing costs in combination with high economic growth reduced the real value of debt and stimulated to increased borrowing by governments in several euro countries in order to finance fiscal deficits which further worsened their current-account deficits, especially in Greece and Portugal. Excessive public spending stimulated private investment

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Figure 2.1: Source: Eurostat. Average general government budget balance between 2003- 2007 as percent of GDP

which translated into larger current-account deficits, i.e. the twin deficit. In other countries, such as Ireland and Spain, the debt accumulation was mainly private as the credit boom significantly increased consumption and investment in these countries. However, private debt accumulation was evident also in several other euro-countries. By looking at loans to the private sector from domestic banks and other credit institutions as percent of GDP, Lane (2012, pp. 52-53) shows how especially Portugal, Ireland, Italy, Greece, and Spain experienced significant increases in private credit dynamics between 1998 and 2007, while Germany’s and France’s credit dynamics were relatively stable at a high level through the period. E.g while Greek private sector loans increased from 56.5 percent of GDP in 2002 to 84.4 percent in 2007, German private credit dynamics were relatively stable around 110 percent. Figure 2.1 shows the average general government budget balance between 2003-2007 among several countries in the eurozone³. Among the countries who would later be hit hardest by the European debt crisis it is clear that Ireland and Spain performed remarkably well as the debt accumulation was mainly private, while Italy was just marginally below the Maastricht criteria. Among the countries that would not be severely hit by the crisis, i.e. Germany, Netherlands, and Belgium, the figure shows that they all ran fiscal deficits. The large deficit in Greece was not solely a result of too high public spending - it was mainly due to an ineffective administrative State which made possible an extreme level of tax evasion which created a large difference between expenses and revenues (Wolf, 2014, p. 46). In his article Why austerity is the only cure for the eurozone the German Finance Minister Wolfgang Sch¨aubel writes ”Whatever role the markets have played in catalysing the sovereign debt crisis, it is an indisputable fact that excessive state spending has led to unsustainable levels of debt and deficits that now threaten our economic welfare” (Sch¨auble, 2011). However, according to figure 2.1, the argument is not persuasive as the most well performing countries during the crisis did all

3According to Eurostat, the general government sector comprises central government, state government, local government, and social security funds.

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Figure 2.2: Source: Eurostat. Current Accounts in the Eurozone in 2007 as percent of GDP

run deficits, while Ireland and Spain - who were hit hard by the debt crisis after 2007, performed remarkably well.

Consider next the current account imbalances which developed after the adoption of the euro. The governments and private sectors in Portugal, Ireland, Italy, Greece, and Spain enjoyed the credit boom up until 2007 which resulted in increased inflation above the eurozone average, increased prices and wages. Thus the countries became current-account deficit countries with excessive spending over income, relying more on foreign capital inflows. Other countries such as Germany, Netherlands and Belgium focused on reducing labour costs and improve productivity so to further improve their competitiveness, making them current-account surplus countries (see e.g. Holden, 2012; Wolf, 2014, pp. 74-85;

and Lane, 2012). Figure 2.2 illustrates current account imbalances in 2007. First of all, the figure says something about the direction of the capital flow. High-saving-surplus- countries such as Germany, Netherlands, and Belgium invested much of their savings in the dynamic economies of the south. According to Wolf (2014, pp. 59-85) the pattern also suggests strengthening of external competitiveness in surplus countries and declining competitiveness in the deficit countries:

Moreover, these losses of competitiveness were inevitably associated with long- lasting changes in the structure of economies: in surplus countries, industries that produce tradable goods and services, particularly export-oriented man- ufacturing, expanded, as in Germany. In countries with external deficits, the opposite happened: businesses oriented to the domestic economy, such as con- struction and retail, expanded, as in Spain. (Wolf, 2014, p. 63)

And as further explained by Sinn (2014), the periphery countries lost their competitiveness by simply becoming too expensive. The export sector has more potential for productivity growth, thus the imbalance ran the risk of further diverging productivity. The increas-

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ing difference in current accounts and competitiveness created unsustainable imbalances where a financial crisis would have large asymmetric impacts. In 2008 a financial crisis did hit Europe, resulting in a sudden stop of capital inflow into deficit countries. The subsequent worsening of primary deficits was therefore in part a consequence of a crisis - not the reason.

Comparing figure 2.1 and 2.2, one could argue that current account imbalances do a better job in predicting which countries would suffer the most after a financial crisis. If the debt crisis was fiscal in its roots, it is impossible to see from figure 2.1 that it should be Germany who ended up as a safe haven country after the crisis. Since the problem that led to the European debt crisis was the loss of competitiveness among periphery countries, Sinn argues that the eurozone needs to re-balance:

The realignment is necessary to achieve debt sustainability and regain competitiveness, and competitiveness is a prerequisite for new growth. Keynesian demand stimuli is not sustainable. At best it is an improvement in capacity utilization. Sustainable growth, by contrast, will only result if a country is truly competitive in the sense of being inexpensive enough, given the nature and quality of its products, to enjoy high demand for its products from abroad and to be an attractive business location. (Sinn, 2014, p. 5)

The challenge is that the current accounts are jointly determined so that surplus countries would need to become more expensive in order for deficits countries to be able to regain competitiveness. Sinn calls for an opposite Keynesian policy where deficit countries need austerity and internal devaluation in order to regain competitiveness whereas surplus countries could benefit from fiscal expansion and inflation. Austerity is a rough medicine and brings with it adverse economic, social, and political effects and is experienced as a punishment by any country who gets such a medicine imposed on them. Therefore, such policies raise a moral question. According to Wolf: ”The surpluses entail deficits and vice versa. Because they are jointly determined, it is logically impossible to say that countries in deficit are responsible for their plight while those in surplus are guiltless. That is childish moralism” (Wolf, 2014, p. 63). The deficits of Greece were made possible by the investments from the surplus countries. This is only one aspect of the heated debate regarding the economics of austerity. ⁴.

2.3.2 Greece after 2007

At the onset of the financial crisis, Greece ran a current-account deficit of almost 15 percent of GDP and a government-budget deficit of around 10 percent of GDP. The country

4For a more complete overview of the origins of the European sovereign debt crisis, see Holden (2012), Lane (2012), Wolf (2014), and Abbas et al. (2014).

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mainly relied on running a foreign-capital surplus as it ran both a current-account -and a budget deficit after high spending by successive governments relative to revenues raised.

But as the foreign-capital surplus is very responsive to risk and uncertainty, the outbreak of the worldwide financial crisis was the starting point for a sudden stop in capital inflow which decreased the foreign-financial surplus, forcing Greece to lower its deficits. Since currency devaluation is not an option in a monetary union, Greek wages fell and GDP was reduced through internal devaluation resulting in a recession which increased the debt-to-GDP ratio.

2009 was a critical year for Greece as new revisions about Greek debt and primary deficits were made and published by the newly elected government led by Prime Minister Georgios Papandreou, and it turned out to be a lot worse than earlier reported. The budget deficit forecast for 2009 was revised from around 6 percent to GDP to around 12 percent. Fiscal mismanagement and deception through misreported statistics throughout the period from 2001 when Greece joined the euro harmed investor confidence when the true numbers were revealed, hence increasing borrowing costs and raised the spreads on sovereign bonds. The sudden stop in capital inflow in combination with low investor confidence made it almost impossible for Greece to finance its deficits. Greece was the first country to be shut out of the bond market in May 2010 when Greek government bonds got junk status and the private capital market froze⁵. The country was in desperate need of financial aid in order to avoid default. Since then, Greece and its creditors have agreed upon three bailout packages in total. The first package of 110 billion euro bailout loan were agreed upon in May 2010 where 80 billion were financed in the form of bilateral loans from by the euro area Member States and additional 30 billion came from the IMF.

The time horizon of the package was three years, but this proved to be too short a time by far in order for Greece to satisfy the conditionality. Hence, the first package was soon followed by a second package of 164.5 billion euro loan (an additional 130 billion plus the undisbursed amount from the first package) agreed upon in 2012, financed by the EFSF and the IMF. The loans were to be transferred in smaller disbursements during the next three years given that the conditionality criteria were met. The conditionality can be summarized into the four areas of restoring fiscal sustainability, safeguarding financial stability, enhancing growth, competitiveness and investment, and developing a more modern State with a public administration. The last point was motivated by the fact that Greece have had a highly inefficient tax system with a high degree of tax evasion, one of Europe’s most generous pension systems, and an inefficient public administration with a poor history of fiscal discipline. However, the criteria were not met, meaning that funds were often withheld until they were (Kuttner, 2013, p. 148). When the EFSF programme expired in June 2015, 130.9 billion euros were still outstanding. A third bailout loan of

5Greece did not re-enter the bond market before July 2014

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Figure 2.3: Source: Macrobond. Quarterly evolution of Greek public debt

86 billion euros, provided by the ESM and the IMF, was agreed upon in 2015 in order to further repay the creditors, pay down interest and recapitalize banks⁶.

The Greek public debt has been steadily increasing up until the bailout packages. Fig- ure 2.3 shows the quarterly evolution of the Greek public debt from 2005-2015, reaching an all time high of approximately 369 billion euro in December 2011. The large drop in 2012 corresponds to the component of the second bailout package which included ”Private Sector Involvement” (PSI) which resulted in a face value loss of 53.5 percent on 97 percent of all privately held Greek bonds. According to Arslanap and Tsuda (2012), Greek sovereign debt held by domestic banks at that time were about 15 percent of the total, making the public sector exposed to a banking crisis and the banking sector exposed to sovereign default. About 10 percent of the total were held by domestic nonbanks. The debt relief put downward pressure on the debt crisis but resulted in large losses among banks and nonbaks which held Greek bonds. Except from the PSI, the debt continued to rise after the two first packages. By dividing the the total amount into smaller disbursements, providing them conditionally on good behaviour, clearly undermined the effectiveness of the loans.

Figure 2.4 shows the unemployment rate between 2004-2015, being above 25 percent between 2013-2015. The unemployment rate was averaging approximately 16 percent between 2004-2015. According to the Greek National Statistical Service, the unemployment rate for workers between 20-24 years old exceeded 55 percent in 2013, and exceeded 70 percent for youths between 15-19 in the same year. As the budget deficit was reduced through austerity measures during 2011-12, increased unemployment followed as a side effect.

6A complete overview of the amounts and dates of the disbursements is available at:

http://ec.europa.eu/economy finance/assistance eu ms/greek loan facility/index en.htm

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Figure 2.4: Source: Macrobond. Greek unemployment rate

Figure 2.5 illustrates the treasury yields on 10-year Greek government bonds compared to those of Germany, Italy, and the United Kingdom. Except from the British pound, the sovereign debts are denominated in a common currency, the euro. This implies that the yield curves mainly reflect the credit-risk perceptions for each individual country. From the 1990s to the beginning of the 2000s there was a period of convergence as the countries prepared their entry into the EMU. Greece had experienced high inflation and exchange rates vis-`a-vis its trading partners, but managed to improve its position as the country prepared to meet the Maastricht criteria through fiscal adjustments. The interest rate on Greek bonds converged later than the interest rate on the countries’ debt as Greece was the last country to join the eruo in 2001. The figure shows that the interest rates on both German and British debt have been relatively stable trough the period. German debt has benefited from a safe-haven response as the Greek and Italian debt have been perceived as more risky, exactly in line with Dornbusch’s argument of market discipline.

It is clear that ”Germany [one of Greece’ major creditors], the country that gave us the word schadenfreude, has been profiting from the misfortune of others” (Kuttner, 2013, p. 115). In the case of the United Kingdom, the country always has the opportunity to print new money in order to pay down debt. Because of this opportunity the interest rates on British debt have followed almost the same safe pattern as those of Germany.

The low spread on sovereign debt between 2000 and 2009 reflects how investors perceived the credit risk within the EMU as low and a fiscal crisis as unlikely, and there were no longer any risks associated with exchange rates - resulting in a period of harmony in the sovereign-debt market. This probably also reflected that the no-bailout clause of the Maastricht treaty had little or no credibility. However, a large increase in Greek yields started in 2009-10 when the true national statistics were revealed, the capital inflow into Greece froze, and Greece received its first bailout package. It is interesting to note how the yields remained relatively stable during 2008 and 2009 even though the financial crisis

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had spread to Europe. According to Lane (2012), during those years, investors may have not fully anticipated a sovereign-debt crisis, as the main focus was on saving the banking system. However, this changed as the distress in the banking sector soon became a problem of macroeconomic fundamentals. Even though Greece got its first bailout package in 2010, the interest rate continued to increase until the beginning of 2012. This says something about how investors interpreted the austerity package and its ability to save Greece and how the austerity affected confidence. In addition, the announcement of the PSI component of the second package and the complicated negotiations concerning its magnitude contributed to drive the interest rate further upwards. The final agreement on the second bailout package, the implementation of the PSI, and the announcement of new monetary policy instruments created by the ECB who was ”ready to do whatever it takes” to stabilize the eurozone (discussed in depth in later sections) made the interest rate decline in 2012. Hence, even though the history is repeating itself through diverging interest rates on sovereign debt, the divergence during the last years is happening for fun- damentally different reasons than in the case of 1990. At the time of writing, the interest rate on Greek bonds is again increasing.

Finally, table 2.1 summarizes Greek key macroeconomic numbers in a table. Especially interesting are the government budget balance and debt-to-GDP ratio which were never close to meet the Maastricht criteria. As austerity slowly reduced the budget- and primary balance from 2009, the Greeks has suffered from adverse side effects such as reduced minimum wage and increased unemployment. There were also significant side effects in the overall growth of the economy. The annual change in real GDP growth from 2009 has been negative throughout except from 2014. Greek GDP growth had its worst year in 2011 with a growth rate of -9.1 percent. In 2014 the real growth rate turned positive, but at the time of writing the growth rate is again negative. The European Commission projects a real GDP growth rate of -0.7 in 2016. The austerity measures are supposed to improve Greek competitiveness. The current-account deficit has been almost continuously reduced since 2008, but this is mainly a result of a larger reduction in imports relative to the reduction in exports since 2007. According to Sinn:

The reason for the current account deficit improvements is primarily a strong decline in imports, which did not signal an improvement in competitiveness but was simply a result of the recession. Declining incomes and mass unemployment constituted an income effect that necessarily reduced imports.

(Sinn, 2014, p. 7)

The GDP price deflator in table 2.1 shows that prices have fallen from 2013 and onwards relative to the 2010 base-year. Thus, cheaper domestic goods and services could shift demand from imports towards domestic oriented goods and services. Further, the price

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Figure 2.5: Source: Macrobond. 10-year yields on government bonds among four european countries

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Table 2.1: Source: The Bank of Greece, Eurostat, and AMECO. Economic Statistic Table for Greece between 2007-2016

Year

2007 2008 2009 2010 2011 2012 2013 2014 2015 2016

Nominal GDP 232.7 242.0 237.5 226.0 207.0 191.2 180.4 177.6 175.7 174.4 Public debt 239.9 264.7 300.9 330.4 356.0 304.8 319.2 317.1 314.4 322.7 Debt-to-GDP

ratio 103.1 109.4 126.7 146.2 172.0 159.4 177.0 178.6 179.0 185.0

Primary balance -2.2 -5.4 -10.1 -5.4 -3.0 -3.7 -8.4 0.4 -3.5 0.5

Budget balance -6.7 -10.2 -15.2 -11.2 -10.2 -8.8 -12.4 -3.6 -7.6 -3.4 Real GDP

growth rate 3.3 -0.3 -4.3 -5.5 -9.1 -7.3 -3.2 0.7 -0.2 -0.7

Unemployment

rate 8.4 7.8 9.6 12.7 17.9 24.5 27.5 26.5 25.1 24.0

Treasury yield on

10-year gov’ bonds 4.5 4.8 5.17 9.09 15.74 22.81 10.05 6.92 8.86 9.41 Current account

balance -15.6 -15.8 -12.5 -13.11 -10.3 -4.2 -2.2 -3.0 -1.8 -1.4

GDP price

deflator 92.8 96.8 99.3 100 100.8 100.4 97.9 95.6 94.7 94.7

Price deflator exports

of goods and services 92.7 96.7 94.6 100 105.8 108.5 106.6 104.6 96.5 98.5 Minimum wage 730.30 794.02 817.83 862.82 862.62 876.62 683.76 683.76 683.76

Notes: Nominal GDP: at current prices in billion euros (AMECO). Public debt: general government consolidated gross debt in billion euro (AMECO). Debt-to-GDP ratio: general government consolidated gross debt divided by nominal GDP at current prices (AMECO). Primary balance: net lending or net borrowing as percent of GDP, excluding interest (AMECO). Budget balance: general government net lending or net borrowing (AMECO). Real GDP growth rate: percentage change (in volume) on precious year (Eurostat), where the number for 2016 is a forecast by the European Commission. Unemployment rate: unemployed persons as a share of the total labour force (AMECO). Treasury yield on 10-year government bonds: yearly average yields expressed in percentages (the Bank of Greece), where the interest rate for 2016 is calculated as the average rate applying from January-April. Current account balance: balance on current transactions (percentage of GDP at market prices) with the rest of the world (AMECO). GDP price deflator: average of national growth rates weighted with current values in euro with base-year 2010 (AMECO). Price deflator exports of goods and services: average of national growth rates weighted with current values in euro with base-year 2010 (AMECO). Minimum wage: in EUR/month (Eurostat).

deflator for exports of goods and services has not changed much from the base year of 2010. Export prices have declined by even less than the GDP price deflator. Thus, as the austerity has reduced the primary surplus and the current account at the expense of unemployment and growth, little has happened to improve Greek competitiveness as the current-account deficit has been reduced because of increased unemployment rather than lower relative prices. ”Plainly, Greece [...] have a particular long way to go to achieve debt sustainability, but practically none of the necessary adjustment has taken place yet, despite the fact that the crisis has lasted already more than five years” (Sinn, 2014, p. 6).

To summarize, the fact that Greece joined the monetary union with misreported statistics about key macroeconomic variables put the Maastricht Treaty and Dornbusch arguments to a test. Greece had clearly violated the debt-to-GDP and budget deficit criteria.

However, the excessive spending and current-account deficit of Greece were made possible

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by foreign-capital inflow from surplus countries such as Germany. ”Yes, the Greeks should have paid their taxes and run their government more responsibly. But the fact that they behaved in this way was really no secret. Caveat creditor - let the lender beware- is a good motto” (Wolf, 2014, p. 182). Thus, the financial crisis, in combination with reduced investor confidence when the true statistics of Greece went public, resulted in an asymmetric shock of huge proportions. The no-bailout condition needed to be relaxed in order to save Greece from default, resulting in three bailout packages in total between 2010-15.

The conditionality and austerity measures agreed upon during the bailout negotiations proved to be costly as they resulted in severe adverse effects. This triggered the debate about whether economic recovery and structural reforms in the eurozone should indeed be done through fiscal austerity or Keynesian expansions and debt restructuring. The remaining part of this chapter will discuss this further.

2.4 The Sustainability of the Greek Sovereign Debt

2.4.1 Examples of Models of Debt Crises

In 2011 Greece partially repudiated on its debt after investors accepted a 53.5 percent face value loss in their Greek debt holdings. It is the fear of such losses that drives the interest rate on bonds. The rate of interest is dependent upon investor’s confidence in the the country’s ability to honour its debt and the history of repudiation. A history of repudiation gives reasons for investors to be pessimistic about the country’ repayment ability which again opens the possibility of several equilibria and self-fulfilling expectations in the market for sovereign debt. Calvo (1988) develops a model where he shows how partial repudiation often is a best response for the government. In this economy, multiple debt equilibria exist and they are a function of consumers’ expectations about future repudiation. He models taxation as distortionary i.e. the deadweight cost of taxation is an increasing convex function of the tax level. The fact that taxation, here the only way to pay down debt, has a cost gives the government an incentive to renege on the debt. But repudiation also comes with a cost which is proportional to the amount being repudiated, and this cost is also financed by taxation. Without describing the two-period model in detail, multiple equilibria exist because consumers’ expectations about possible repudiation is reflected in the interest rates on government bonds. Those expectations are based on the level of existing debt, the cost of repudiation, and the governments optimal taxation. If the consumers believe that the level of taxation is not sufficient in order to pay the debt in full, they will demand a higher interest rate which makes it more difficult for the government to actually do so. Thus, debt repudiation is a self-fulfilling prophecy.

Calvo writes:

our results suggest that postponing taxes (i.e. falling into debt) may generate

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the seeds of indeterminacy; it may, in other words, generate a situation in which the effects of policy are at the mercy of people’s expectations - gone would be the hopes of leading the economy along an optimal path. (Calvo, 1988, p. 648)

According to this theory there are possibilities of several equilibria. Relative to the good equilibrium where optimistic expectations and low interest rate result in full downpayment of the debt, the bad equilibrium is Pareto-dominated as everyone would be better off in the good equilibrium case. Though not modelling Greek default as a best response in a game theoretic sense in the model used later in this chapter, the model builds on the idea that the interest rate is driven by expectations which creates several equilibria in the bond market.

Building on this theory and inspired by the Mexican debt crisis of 1994-95, Cole and Kehoe (2000) develop a model which shows how a self-fulfilling debt crisis can be triggered by loss of confidence in the government. For given values of fundamentals such as the government’s debt level, its maturity, and the existing capital stock, the ability of the government to roll over its debt is determined by the probability the investors assign to the governments ability to repay in the future. They characterize three zones: the crisis zone, the default zone, and the no-crisis zone. By applying this model to Greece one could find several interesting implications. Suppose the extremely high debt level puts Greece in the crisis zone so that a debt crisis can occur with a positive probability. Then, according to the model, investors will anticipate a possible default, hence the price the investors are willing to pay for government bonds is depressed. This makes it more difficult for the government to roll over its debt and is therefore forced to reduce government spending.

In the final step of the game the consumers make an optimal decision about consumption and capital accumulation, taking future productivity and the previous moves made by the financial markets and the government as given. If the government defaulted in the previous period or the consumers expect a default in the future, this may harm the governments reputation which affects the productivity of the economy in future periods.

This will in turn result in lower output and consumption and enable a subsequent crisis.

Greece is then trapped in a bad equilibrium as lower investor demand, reduced government spending, lower consumption and capital accumulation are mutual best responses by all agents in the economy. The assumption that a debt crisis can be triggered by pessimistic beliefs among investors in the financial market gives the government incentives to pay down its debt faster in order to avoid the spiral. Moving across the threshold from the crisis zone to the non-crisis zone will boost investor demand, reduce interest rates on government bonds, and increase productivity as investors and consumers no longer assign any probability to the possibility of default. The model shows the importance of getting the debt level stabilized at a sustainable level as this will have positive effects on

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the overall economic performance. Countries can find themselves in very different equilibria with only small differences in fundamentals. The authors conclude that ”overall, our model implies that the only way to avoid debt crisis is to avoid the conditions on fundamentals that make them possible: in particular, relatively high levels of debt with a short maturity structure” (Cole and Kehoe, 2000, p. 110). The model applied next will focus on a similar link between debt, interest rate, and economic activity, and is thus inspired by the body of work mainly attributable to these authors.

2.4.2 The Algebra of Sustainable Debt and Some Theories on Debt Accumulation

This section will describe a standard model of sustainable debt as often applied by the IMF. The notation used in this section is taken from Mehlum (2012). By definition, debt is sustainable if the level of debt does not grow faster than the GDP and it is possible to hold the debt-to-GDP ratio constant over time. The evolution of debt, ∆B, is determined by down payment, H, and interest on the existing debt,r

∆B =rB−H (2.1)

Suppose that g denotes the growth rate of GDP. Since a sustainable debt level by definition does not grow faster than the GDP, then the maximum change in public debt the government can afford according to the definition of sustainability is given by

∆B =gB (2.2)

Finally suppose that the amount of resources for downpayment are determined by the size of the primary surplus, denoted a, as a fraction of GDP and rewrite the requirement for sustainable debt into

gB =rB−aY (2.3)

where (2.2) have been inserted into (2.1) andB denotes a sustainable debt level. It follows that the sustainable debt ratio, S, is

S= B

Y = a

r−g (2.4)

Thus, the higher the economic growth and primary surplus, the higher the debt level could be and still be sustainable. Consider the Greek numbers for 2015 which showed a real GDP growth rate of -0.2 percent and a primary balance of -3.5. According to

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the IMF, the effective interest rate⁷ was projected to be 2.1 percent conditional on full implementation of the program (IMF, 2015, p. 19). By using this interest rate as an approximation for the true borrowing costs on official Greek borrowing, this corresponds to a sustainable debt level of approximately -85 percent of GDP⁸, while the actual debt level is 179.0! This implies that the only sustainable scenario for Greece, given the large deficit and absence of growth, is to be a creditor - not a debtor. Thus, in the current economic environment, Greece is extremely far from achieving a constant debt-to-GDP ratio over time according to equation (2.4).

The fact that Greece is far from able to keep its debt-to-GDP ratio constant over time is illustrated in figure 2.6. The figure illustrates the evolution of the Greek gross government debt as percent of GDP compared to Germany and the entire euro area. The ratio has been increasing almost the entire period, except from a small decline in 2012 due to the PSI and bailouts. According to the IMF, debt sustainability is defined as an debt-to-GDP ratio less than 120 percent. In the figure, this threshold were crossed in 2008 and the debt has been unsustainable ever since. By comparing figure 2.6 and figure 2.3 it is clear that the drop in the debt-to-GDP ratio in 2012 is small relative to the large drop in public debt which was made possible through the debt relief the same year. However, table 2.1 shows an extremely low GDP growth rate of about -10 percent of GDP. Thus, even though private holders of Greek debt accepted a face value loss which reduced Greece’s total debt burden, the debt-to-GDP ratio was reduced by only a modest amount because of the low growth of the Greek economy. This clearly shows how a debt relief has a limited effect on the debt-to-GDP ratio if the economy is not able to produce any economic growth.

At this point it is relevant to ask why and how several Greek governments could al- low such an enormous debt accumulation. The elevating debt-to-GDP ratio after 2007 is clearly a result of the sudden stop in capital inflow which significantly increased the real value of debt as the economy went into a recession. But why the high level of debt in the first place, besides the institutional failures of the EMU? Typical macroeconomic text- book explanations for debt accumulation is mainly about tax smoothing and the strategic debt accumulation theory from political economy.

Consider the model of tax smoothing by Barro (1979). The intuition is that, assuming that marginal distortion of raising tax revenues is increasing in the amount of tax revenues raised, smoothing taxation minimizes the distortions. This implies that running a bud-

7”Defined as interest payments divided by debt stock at the end of the previous year” (IMF, 2015, p.

19).

8S= 0.021−(−0.02)^−0.035 =−85 percent.

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Figure 2.6: Source: Eurostat. Evolution of Greek gross government debt as percent of GDP

get deficit might actually be an optimal response by the government when anticipating a fall in future government expenditures. When economic shocks are anticipated, such as wars or recessions, fiscal imbalances might be preferable as changes in the tax policy creates distortions⁹. This provides a rationale for debt accumulation through debt issuance.

However, Greece has shown a systematic tendency towards high deficits regardless of the variation in government expenditures which casts some doubt on whether this model is a good approximation for Greece.

Suppose current Greek policymakers may believe that the future policy will be set by political opponents who they disagree with, hence the current policymakers use their position to distribute resources in a way they see most appropriate, and by doing so excessively they restrain the government spending of future governments by running strategic deficits. Alesina and Tabellini (1990) argue that the equilibrium stock of public debt in democracies tends to be larger than what is socially optimal because of the uncertainty of whom will be appointed in the future. Given this uncertainty, and with sufficient polarization between political parties who disagree on the composition of public expenditures, each party will not fully internalize the full cost of public debt. Since deficits and debt accumulation represent future tax distortions and less scope for public spending, the party in power is concerned about the trade-off between those negative effects with the probability of staying in office and of who is paying the bill in the future. Hence, democracies exhibits higher deficits and debt levels than in the case of a social planner appointed for-

9Within the Keynesian framework we can show that, by settingG=T and assume a balanced budget, the multiplier increases compared to the case when keepingT fixed, implying budget deficits/surpluses whenGvaries. Hence, any negative shock to the interest rate is more destabilizing when running balanced budgets as the IS-curve is less steep in this case.

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ever. In Greece during the last three decades, PASOK (Panhelleninc Socialist Movement) and ND (New Democracy) alternated in power until the election in 2009. Whether the model of Alesina and Tabellini applies to Greece in this period depends on the degree on polarization between the two parties. According to Pappas: ”Greek polarization has been strategic polarization, pursued deliberately by pragmatic parties competing to grab the state single-handedly and control its resources” (Pappas, 2013, p. 40). As the deficits and debt grew rapidly under both parties, one could argue that the model implications could contribute in explaining parts of the excessive government spending up until 2009.

The two-party system of Greece might also have led to continuously delayed stabilization. Policymakers may agree that the deficit should be lower but still being unable to agree on the policy which can achieve it. ”Specifically, inefficient deficits can persist because each policymaker or interest group delays agreeing to fiscal reform in the hope that others will bear a larger portion of the burden” (Romer, 2012, p. 617). Alesina and Drazen (1991) develops a mathematical model and illustrate that the larger the benefits of continuing to delay relative to accept the reform, the more likely is a war of attri- tion. Delayed stabilization is a function of political polarization and the authors mention several examples of this. For example after WWII there was an agreement to reduce the large deficits that resulted after the war but there was often much disagreement over what groups in society that should pay in form of increased taxes, and this delayed the fiscal stabilization in several countries. The authors assume that the pre-stabilization process is characterized by inefficient methods of financing government expenditures and widespread political lobbying which are direct costs for all. However, a stabilization agreement means moving away from inefficiency which benefits all. How long the delay will last is determined by how long it takes before one political part (representing a socio-economic group) agrees on bearing a disproportionate share of the tax increase. Agreement happens when the cost of delay is less than or equals the cost of postponing reforms. But as the debt level increases, so too does the difference between the payoffs for the winners and losers.

Thus, each political part will devote more time to lobbying in order to induce its rivals to concede. The model of Alesina and Drazen assumes two polarized parts which has been the case with ND and PASOK in Greece up until 2009. However, after the crisis, the two-party system changed into an ”extremely polarized form of multipartism” (Pappas, 2013, p. 43) The theory is still appealing in a way that, as policy is set by several parties representing several socio-economic groups, this may delay reforms depending on the het- erogeneity between them. This has been especially evident from the complex bargaining processes over structural reforms and austerity measures since the first adjustment programme. However, one could also argue that the scope of the current Greek crisis is of a magnitude so great that the cost of delaying fiscal corrections clearly outweighs any gains from delay.

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2.4.3 The Vicious Spiral between Investor Confidence, Growth, and Sustainability

”I will have my bond” - Shylock, in William Shakespeare’s ”The Merchant of Venice”

Subsection 2.4.2 showed how a high primary surplus only had a positive effect on the level of sustainable debt. However, since primary surpluses represent fiscal consolidation it may be reasonable to assume that the variable will affect both the interest rate and economic growth. Now suppose there is a critical level of primary surplus so that if the primary surplus needed for debt sustainability exceeds this critical level it will affect investor’s confidence. As a response to crossing this level, investors demand a risk premium in order to be willing to buy sovereign debt. With a high level of debt in combination with low economic growth and high borrowing costs, Greece is forced to accomplish a high primary surplus, i.e. a high a, through austerity measures which hamper further growth and increases unemployment. Hence, investors demand a risk premium,e(a), which again affects the required a for sustainable debt as it increases the borrowing costs for the government.

This assumption is consistent with several empirical findings. According to von Ha- gen et al. (2011), their empirical strategy identifies a significant relationship between budgetary positions and risk premiums on government bonds in the euro area countries relative to safe haven German bonds. They use data up until 2009 and find that markets penalise fiscal imbalances in the form of fiscal deficits and debt much more strongly than before. During the post Lehman-crisis they find that elasticities for deficit differentials (relative to a benchamrk country) are three to four times larger than earlier, and those for debt differentials are seven to eight times larger (higher debt differential is often ac- companied by higher interest rates and low growth, further affecting the required a and risk premiums). The euro area countries should, they argue, pay much more attention to their budgetary positions in order to safeguard against the high costs of public debt. For Greece, relatively weak fiscal performance explains around half of the increase in spreads during the financial crisis according to he authors. Laubach (2009) finds that the esti- mated effects of government deficits and debt on interest rates are statistically significant and economically relevant. The risk premium increases by 4 basis points per percentage increase in the debt-to-GDP ratio over 60 percent. This method is suggested by the IMF staff when they forecast the future borrowing cost. In their report they suggest that:

Borrowing from the market is assumed at an average maturity of 5 years and average nominal interest rate of 6.25 percent for the next several decades.

The Economics of Austerity and the Vicious Spirals of Greece

The Economics of Austerity and the Vicious Spirals of Greece

Nikolai Vike

Master´s thesis for the degree

Master of Economic Theory and Econometrics Department of Economics

UNIVERSITY OF OSLO

The Economics of Austerity and the Vicious

Spirals of Greece

Summary

Preface

Contents

List of Figures

List of Tables

Chapter 1 Introduction

Chapter 2

The Greek Crisis and Recovery:

Fiscal Corrections with Adverse

Effects in the Market for Sovereign Debt

2.1 Fiscal Aspects of Monetary Integration: Why the Experiment Should Work

2.2 What Went Wrong?

2.3 An Overview of the Greek Debt Crisis

2.3.1 An Unbalanced Eurozone

2.3.2 Greece after 2007

2.4 The Sustainability of the Greek Sovereign Debt

2.4.1 Examples of Models of Debt Crises

2.4.2 The Algebra of Sustainable Debt and Some Theories on Debt Accumulation

2.4.3 The Vicious Spiral between Investor Confidence, Growth, and Sustainability