Greek Crisis: Tragedy or Opportunity?

Prof. M. Subramanian

Introduction

Introduction
Following the financial crisis of 2008 and the increase in budget deficits and

public debt levels of governments intent on providing economic stimulus and

bailing out national banks to various degrees around the world, sovereign credit concerns became a renewed focus of the financial markets in 2009. Greece suffered from the highest debt to GDP ratio in Europe and chronic budget deficits. A new Government was formed following a general election in October 2009, revealed that previous deficit estimates for the year had been optimistic, and announced that they were over 15 % of GDP, more than twice previously claimed. The interest rate on newly issued Greek sovereign bonds increased dramatically over concerns by market participants that the country might not be able to repay its debt in full. By May of 2010, as the interest on the two year notes reached 19%.

Introduction
Greece had effectively lost access to the capital market and the ability to refinance its debt. With over 20 billion coming due within a few weeks, it faced the very real possibility of having to default on its upcoming interest payments. This would have been the first default by a country of the European Monetary Union since the introduction of the euro in 1999, and there were powerful motives to avoid it. In order to prevent such liquidity crisis Greece turned to two international Institutionsthe European Union (EU) and the International Monetary Fund (IMF)which organized an emergency loan unprecedented in its size relative to GDP. In return Greece agreed to implement a harsh fiscal retrenchment program, reducing salaries and pensions for public employees, raising the retirement age, cutting services, and increasing taxes. The process of reaching agreement on the package among the 17 countries of the Eurozone was politically and administratively complex. In particular voters in Germany opposed what they perceived as footing the bill for what they considered a profligate state. Also, the rules of the European Union explicitly forbade bailoutsintended as fiscal transfersamong member countries.

Introduction
The EU and IMF loans were designed to meet Greeces financing needs for

the next three years. But long-term questions remained.

When the EU and IMF loan program ended, would Greece have its fiscal house in order, or would it ultimately be forced to default or restructure its debt? Could Greece attain the primary budget surplus necessary to stabilize its high debt-to-GDP ratio, or would the upcoming fiscal consolidation and necessary internal deflation undermine growth and prove socially unacceptable? As it turned out, the Greek debt crisis was only the beginning of a Europewide sovereign debt crisis that would test European unity to the core. An even larger Europe-wide financial safety net The European Financial Stability Fund (EFSF)was unveiled by the EU and the IMF just a week after the announcement of the Greek package. Both Portugal and Ireland requested financial help from the EFSF shortly after it was established.

Questions to be answered, now

1. How did Greece get into this difficult situation? Whose fault was it? 2. Would you buy GGBs now? 3. Does the Greek crisis spell doom for the future of the euro and the euro area?

Step-by-Step approach @ Questions

1. Was the fiscal crisis unequivocally Greeces fault? Was it

the irresponsible, dishonest? Were the causes structural

/ political / institutional / cultural?

2. Was Greece assuming it would be bailed out?

3. Could you have seen this crisis coming from the data? Was it inevitable?

Step-by-Step approach @ Questions

4. Was the crisis the fault of the euro? Of Germany?

5. Was it wise to allow Greece to borrow at such cheap rates after joining the euro? Were the Germans not happy that Greeks could finally afford to buy Porsches and Mercedes ?

6. Why did the German and the French banks lend so

much?

Step-by-Step approach @ Questions

7. Why did it take so long to agree on a rescue of an economy
that is only 2.6% of the Eurozone? Was it a good idea to get
the IMF involved? Why was the loan relatively generous? 8. Was the ECB acting responsibly or beyond its mandate?

9. Was it the fault of the markets? Were they overoptimistic in

marking the spreads down so much so fast? Are they over pessimistic now? 10. Why did they react so negatively to the first package? Why so much volatility, why are the markets so unsure?

Step-by-Step approach @ Questions

11. Exactly one year after the package was announced, the 10

year GGB could be bought for 50% of par, yielding 15.3% in

euros. That is a yield to maturity of over 30% in euros. Would you have invested in it knowing what you knew at that point in time? 12. If Greece were to restructure its debt through a haircut, or a lengthening of maturities would it spell the end for the euro and the Eurozone? For the EU?

13. Is a break-up of the euro conceivable? What would Europe

look like?